VOLUME FOUR
FUNDING, AND ASSET AND LIABILITY MANAGEMENT

 

 

 

CHAPTER 7
TREASURY AND THE MANAGEMENT OF
ASSETS AND LIABILITIES AT THE STATE BANK

 

 

TABLE OF CONTENTS

7.1 INTRODUCTION

7.2 SCOPE OF THE INVESTIGATION

7.3 ASSET AND LIABILITY MANAGEMENT AND THE ROLE OF A TREASURY IN A BANK

7.4 EVIDENCE AS TO THE ORIGINS AND DEVELOPMENT OF ASSET AND LIABILITY MANAGEMENT AND TREASURY OPERATIONS IN THE STATE BANK
7.4.1 MR G S OTTAWAY (JULY 1984 - JULY 1986)
7.4.2 MR J T HAZEL (OCTOBER 1984 - JULY 1987)
7.4.3 MR T L MALLETT AND MS J A MEEKING (MAY 1987 - NOVEMBER 1990)
7.4.4 THE REPORT OF KPMG PEAT MARWICK HUNGERFORDS (SEPTEMBER 1989)
7.4.5 MR S G PADDISON (JULY 1989 - 1991)
7.4.6 MR S C TARGETT (DECEMBER 1988 - 1991)

7.5 ISSUES WHICH ARE RAISED BY THE EVIDENCE
7.5.1 THE FIRST ALMAC
7.5.2 THE SECOND ALMAC
7.5.3 GLOBAL RISK MANAGEMENT
7.5.4 ISSUES RELATED TO TRANSFER PRICING AND THE COST OF FUNDS
7.5.4.1 The nature of and need for transfer pricing
7.5.4.2 The Relevance of Transfer Pricing to the Allocation of Resources
7.5.4.3 The pricing of funds used in lending transactions
7.5.4.4 The effect of the absence of transfer pricing on the reported divisional profits
7.5.4.5 Pricing the Funds used in the Corporate Banking Division
7.5.4.6 Practical difficulties caused by pricing practices during 1990 and 1991
7.5.4.7 Conclusions with respect to transfer pricing
7.5.5 MARKING ASSETS AND LIABILITIES TO MARKET
7.5.6 CASH FLOW FORECASTING
7.5.7 LIQUIDITY MANAGEMENT
7.5.8 RATE RELATED RISKS
7.5.9 THE LONDON TREASURY
7.5.10 THE STAFFING OF TREASURY
7.5.11 THE PROLIFERATION OF TREASURY OPERATIONS
7.5.12 THE RESPONSIBILITY FOR OVERALL ASSET AND LIABILITY MANAGEMENT
7.5.13 THE SYSTEMS USED IN TREASURY AND FOR ASSET AND LIABILITY MANAGEMENT
7.5.14 THE TREASURY AS A PROFIT CENTRE
7.5.15 SOME CONSEQUENCES OF DEFICIENCIES IN THE BANK'S ASSET AND LIABILITY MANAGEMENT
7.5.16 PROBLEMS IN TREASURY AT THE END OF 1990

7.6 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT
7.6.1 TERMS OF APPOINTMENT A
7.6.2 TERM OF APPOINTMENT C
7.6.2.1 The Board of Directors of the Bank
7.6.2.2 The Chief Executive Officer of the Bank
7.6.2.3 Other Officers and Employees of the Bank
7.6.3 TERM OF APPOINTMENT D

 

 

7.1 INTRODUCTION

 

This Chapter examines the way in which the Bank managed its assets and liabilities, and the operations of the Bank's Treasury, during the period under review.

The Treasury is relevant to the management of assets and liabilities because it carries out important specific functions which are part of the overall asset and liability management task. Also Treasury is an area within the Bank which maintains information which is relevant to asset and liability management.

The importance of asset and liability management was recognised by the Bank Board at the time the two amalgamating banks merged and the State Bank of South Australia commenced business on 1 July 1984. In a memorandum to the Board, dated 28 June 1984, with respect to the establishment of an asset/liability management committee, Mr T M Clark said:

"Of vital importance to the new Bank is the management of an interest spread - the difference between what we pay for our money and what we lend it at.

Equally important is the management of the asset and liability side of our Balance Sheet to see that the Bank is safely funded and safely invested.

To oversee the task it is recommended that we appoint an Asset/Liability Management Committee ..."

That statement and the recommendation contained in the memorandum that the Bank appoint an Asset/Liability Management Committee was approved by the Board. A committee ("the first ALMAC") was established.

Nobody has suggested, or could suggest, that the very general objectives set out in Mr Clark's memorandum were inappropriate. Indeed, for the reasons which are discussed in this Chapter, they were, and are, essential to the good management of the Bank. The question is whether the objectives in Mr Clark's memorandum went far enough, and whether the objectives were achieved.

The importance of asset and liability management is also acknowledged in various Prudential Statements issued from time to time by the Reserve Bank of Australia. Prudential Statement D1 which is entitled Supervision of the Adequacy of Liquidity of Banks was issued in February 1990. Although that prudential statement was issued at the end of the period which is the subject of this inquiry, it contains a statement of fundamental principles which were appropriate throughout the whole period.

The preamble to Prudential Statement D1 refers to what should be one of the basic principles of the business of banking. It says:

"...

2. The maintenance of an assured capacity to meet promptly all obligations as they fall due is fundamental to banking. It is the responsibility of the bank's management to ensure that its internal systems and controls are adequate to ensure resources are available to cover potential funds outflows."

Paragraphs 3 - 10 of that prudential statement are concerned with the maintenance of the Reserve Bank's Prime Assets Requirement, namely, the requirement that each Australian bank should at all times maintain a minimum proportion of its Balance Sheet in specified prime assets. The monitoring of compliance with the requirement should be one of the functions of asset and liability management. In the Bank, it was the Treasury that had the responsibility for monitoring compliance with the Prime Assets Requirement during the period under review. Liquidity Management is dealt with in paragraphs 11-20 of the Prudential Statement, which establish a benchmark against which the operations of the State Bank can be assessed. The Prudential Statement provides:

"Liquidity Management

11. In addition to PAR, each bank should ensure that it manages its liquidity prudently and efficiently.

12. Prudent liquidity management should not rest on an assumption that the behaviour of depositors and borrowers will always be within predictable bounds; nor that the bank will always be able to fund any liquidity shortfall by purchased money.

13. A bank requires adequate liquidity to enable it to cover:

* withdrawal of deposits;

* differences in the maturity pattern of assets and liabilities;

* increases in demand for loans, including increased usage of unused overdraft facilities;

* shortfalls in projected cash flows; and

* unplanned expenditures.

14. A bank can use a variety of techniques to meet its liquidity needs:

* holding adequate cash and readily liquefiable assets;

* maintaining assured standby arrangements with other banks;

* development and maintaining a stable core of deposits;

* maintaining a suitably matched maturity structure of assets and liabilities which generates a steady pattern of cash inflow and allows the refinancing of liabilities in digestible amounts; and

* developing its capacity for asset and liability management.

15. The Bank regularly reviews with banks their policies and systems for monitoring and controlling their Australian and global liquidity needs. The Bank seeks to determine that banks are following practices which limit liquidity risks to prudent levels, and that policies are observed and reviewed to take account of changing circumstances.

16. At the core of banks' liquidity management systems there should be a comprehensive monitoring of:

* the maturity profile of its assets and liabilities (including off-balance sheet commitments and transactions);

* the buffer of liquid assets, additional to PAR, to ensure that the bank will be able to absorb day-to-day fluctuations in its liquidity;

* potential sources of deposit volatility; and

* concentration in sources and application of funds.

17. Regular evaluation of the maturity structure and related aspects of banks' assets and liabilities is fundamental to supervision of the adequacy of liquidity. The Bank will explore with individual banks the development of guidelines on the appropriate size of mismatches which they report at various maturities.

18. Banks should ensure that liquid assets additional to PAR are adequate to avoid undue reliance on liability management. Liability management depends on a bank's market status, the depth of the money markets and the general liquidity situation - factors which can change rapidly. Undue reliance on it can risk the need for urgent sale of assets at heavy loss or the purchase of liabilities at interest rates higher than can be sustained in the medium term.

19. The Bank has not set formal ratio requirements in respect of banks' foreign currency operations. Banks are expected to hold an adequate stock of high quality liquefiable assets in suitable currencies. The adequacy of such holdings is reviewed regularly with banks, taking into account the liquidity standards imposed by host authorities and a bank's access to official liquidity support facilities.

20. In assessing banks' foreign currency liquidity, the Bank focuses on systems in place to manage liquidity on a global basis. This is consistent with industry practice; the tendency has been for banks to establish global treasury functions and to manage their foreign currency operations on a global basis."

In the State Bank it was, at different times, a combination of one or more of the Bank's Treasury, the asset and liability management committees, and the Group Risk Management division, which, either formally, or by default, was or were charged with or assumed the responsibility for the management of the Bank's assets and liabilities.

For reasons elaborated in this Chapter, I have found that the controlling forces within the State Bank were so preoccupied by a desire to grow and report increased profit that the necessity for managing Bank's assets and liabilities was not accorded appropriate attention. Also, in some cases, the Board and senior management of the Bank were either unacquainted with principles that should have been known to be fundamental to the operation of the Bank's business or, if they were acquainted with them, they did little to ensure that they were observed. In addition, my Investigation has heard evidence that the implementation of procedures which should have been introduced to properly manage the Bank's assets and liabilities was delayed by the attitude of members of the senior management of the Bank.

As set out in other sections of this Report, the Bank grew rapidly from the time when it commenced business. With the growth came a change in the financing base of the Bank. There was a change from reliance on retail deposits to the raising of wholesale funding. Concurrently, the nature of the Bank's lending services changed as the Bank moved into corporate and overseas transactions. As these developments occurred, the need for asset and liability management expanded, and the demands placed upon the Treasury both increased in number, and became more sophisticated. Sadly, the development of asset and liability management did not keep pace with the Bank's growth.

As the Bank grew, separate Treasury functions developed in London, Auckland, Hong Kong, New York, and Sydney. This Chapter is predominantly concerned with the activities of the Adelaide Treasury. The separate Treasury at Beneficial Finance is considered separately in a later Report to be presented by me.

While there is nothing to suggest that the matters that are the subject of consideration in this Chapter directly and identifiably gave rise to any of the losses which are the subject of my Terms of Appointment, there is clear evidence that, if the asset and liability management had received appropriate attention, the Directors and senior management of the Bank would have had before them information which would have highlighted the changes which were taking place in the Bank's business, and provided them with the opportunity to manage the Bank's business in such a way as to avoid some of the circumstances which made the Bank's losses possible.

My enquiries have revealed many different factors which contributed to the failure of the Bank to manage its assets and liabilities in an appropriate way. A detailed discussion of each would be unduly protracted, and would not fulfil any worthwhile purpose. What this Chapter does is to identify and analyse the more significant deficiencies, in particular those relevant to the Terms of Appointment. An overriding factor that contributed to all the deficiencies is that the Bank simply grew too quickly and outstripped the ability of the Board and senior employees to understand, and put in place, the procedures that were necessary for the prudential management of the growth.

The Investigation has not sought evidence of the systems and procedures in operation in other banks in Australia. To obtain evidence of what did happen in other banks would involve a further lengthy inquiry in its own right. Rather than look at what happened in other banks with a view to establishing an industry standard for asset and liability management, I have preferred to make an assessment of what would have been appropriate for the State Bank, having regard to the particular requirements of the State Bank's own business operations. In so doing, I have been conscious of, and have attempted to avoid, the inappropriate application of contemporary standards to past years. Over the past eight years there have been significant developments in the area of asset and liability management in banks.

It has been possible to determine what was appropriate for the Bank by reference to contemporaneous observations and reports which were made from time to time by officers of the Bank, and independent consultants who were engaged to assess aspects of the Bank's operations. Also the evidence which has been given to this Investigation clearly establishes what was required.

Major conclusions which I have reached as a consequence of this part of the Investigation are:

(a) There was never appropriate overall co-ordination of asset and liability management in the State Bank. Individual operational sections may have carried out discrete functions in a satisfactory way, but the demarcation of responsibility was not clear, and, until about 1990, there was nobody who took an overview of the whole operation with a view to co-ordinating the management of the Bank's assets and liabilities.

(b) The management of liquidity was, until 1990, given almost no consideration. There was an assumption that because of the Government Guarantee, the Bank would always be able to borrow funds.

(c) The failure of the Bank to have in place appropriate policies and procedures gave rise to deficiencies in the information provided to the directors, senior management, and the lending divisions of the Bank, so that there was an inability to identify both changes in the nature of the business which made possible the losses which the Bank has suffered, and the fact that the Bank was actually entering into lending transactions which were, from the outset, destined to be unprofitable.

(d) If the asset and liability management had been carried out correctly, the Board and senior management would have had before them information which would have demonstrated a change in the nature of the Bank's assets and liabilities. They could then have considered whether the growth of the Bank should have been allowed to continue. Possessed of the information which could have been available, a prudent Board should have consolidated its position and suspended growth in the way the Bank Board had contemplated in July 1988.()

(e) Inadequate planning gave rise to inefficiencies and the loss of opportunities to fully maximise the profits of the Bank.

Many witnesses before this Investigation have given evidence that the dominant emphasis was on reporting profits and growth, and that little or no importance was attached to the need to put in place the systems and procedures required to support that growth. Notwithstanding this, assurances were given to the Directors that the information systems were adequate.() The Directors and senior management should have been aware of the fact that the policies, procedures, and systems of the Bank were so far behind the growth that they should have halted the growth until such time as the policies, procedures, and systems caught up, particularly in the light of observations which had been made by the Reserve Bank.()

Generally, the conclusions I have reached are not inconsistent with the broad thrust of a submission which has been made to me by the Bank.()

 

7.2 SCOPE OF THE INVESTIGATION

 

For the purposes of this part of the Report I have interviewed a number of persons who were involved in the treasury operations and the asset and liability management of the Bank. I have also had regard to minutes of the Board and Executive Committee of the Bank and to minutes of an asset and liability management committee which was constituted in September 1988 ("the second ALMAC"). The first ALMAC had been disbanded in July 1987. The investigation has obtained minutes of some, but not all, of the meetings of the first ALMAC. The Investigation has been told that the other minutes were shredded after the committee ceased to exist.

The Investigation has also been referred to parts of the evidence before the State Bank Royal Commission which deal with matters which are the subject of this Chapter.

Finally the Investigation has had the benefit of useful written submissions which were made by the Bank itself, by certain Directors, and by some of the employees and former employees of the Bank.

 

7.3 ASSET AND LIABILITY MANAGEMENT AND THE ROLE OF A TREASURY IN A BANK

 

Management of a Bank's assets and liabilities is necessary, amongst other things, to ensure that the bank has sufficient, but not an excess of, funds available to it to meet its projected needs, and that excess funds are utilised in the most advantageous way. It can also indicate whether there are appropriate margins on lending transactions. In the most general terms, the overriding purpose of asset and liability management is to ensure that the bank operates profitably. It is plainly an important function.

The role of the treasury in a bank will vary according to the needs and nature of the business of the particular bank. Different organisations will choose to manage their businesses in different ways. A task performed by the treasury of one bank may be satisfactorily performed by some other arm of management in another bank, such as an asset and liability management committee, or an individual person.

Prior to the 1980's, few Australian banks had treasury operations. There were no dealing rooms such as exist today. Only the biggest and most sophisticated international banks were active in the financial markets, and the short-term money market was at an early stage of development in Australia. Foreign exchange trading was in its infancy. In December 1983, the Australian dollar was floated on the world currency market, and a number of Australian banks and merchant banks were licensed to deal in foreign currencies. During that year, exchange control regulations were removed, and interest rate controls were relaxed. In 1984, the Treasurer allocated 16 additional Australian banking licences to foreign banks.

During the mid 1980's, communications and computer technologies underwent a revolution. Improved communications between Australia and the major global financial markets, and the introduction of the personal computer, allowed dealing in the financial markets to assume new levels. New financial instruments were developed, and trading volumes increased substantially.

During this period, there was no standard approach among banks. Different banks responded in different ways.

It has been suggested that, in most Australian banks, the policies, systems, and procedures, lagged behind developments in the pursuit of business. The directors and senior management were required to deal with situations in which they had no experience. The State Bank was in this respect, in the same position as most other Australian banks. There was therefore occasion for prudence and foresight.

It has been suggested that all State banks had the objective of developing a wholesale base to complement strong retail banking networks. There was a common objective to develop market share.

Functions, in other banks, which commonly form part of the asset and liability management and treasury operations include the following:

(a) manager of the balance sheet;

(b) manager of the rate related risks, such as interest rate risk and foreign exchange risk;

(c) manager of the prudential assets which are held to satisfy the Prime Assets Requirements of the Reserve Bank of Australia;

(d) manager of liquidity, that is ensuring that the Bank will have funds available to meet its obligations as they fall due;

(e) raising the funds required to meet the Bank's commitments;

(f) the investment of surplus funds;

(g) arbitrage (trading in two or more markets at the same time to exploit profit opportunities created by brief periods of market disequilibrium);

(h) advising the operational divisions of the Bank with respect to the structuring of transactions; and

(i) representing customers of the Bank who wish to deal in particular markets.

While the treasury in a bank is, in many respects, a service department to other divisions of the Bank, a treasury is able to, and in fact, should, derive a profit from its operations. In some institutions, an internal accounting process, known as transfer pricing, is carried out to assess the notional profitability of different divisions. An elementary form of transfer pricing was carried out in the State Bank from the end of 1988. Transfer pricing can help to give some indication of the performance of a bank's treasury as a profit centre. Also, transfer pricing provides a means of measuring the profitability of both individual transactions, and of the lending divisions of the Bank.

One important function of a bank's treasury should be the compilation and dissemination of some of the information which is necessary for the good management of the Bank. For example, a bank cannot accurately price lending transactions unless the bank knows the cost of the funds that are to be used for the purpose of the transaction. The treasury is normally the only division within the bank that has all the information necessary for the pricing of funds to be carried out. Before the information can be promulgated by the treasury, however, it must first be made available to the treasury by the other divisions of the Bank. It is also necessary that the treasury should have appropriate systems to process the information.

 

7.4 EVIDENCE AS TO THE ORIGINS AND DEVELOPMENT OF ASSET AND LIABILITY MANAGEMENT AND TREASURY OPERATIONS IN THE STATE BANK

 

In this part of the Report, I shall discuss evidence given by various persons who held senior positions in the Bank, and the roles that those persons played in connection with asset and liability management and Treasury operations.

From the evidence it has been possible to obtain a picture of the way in which the asset and liability management and the Treasury of the Bank developed. In addition, the evidence has focused upon certain features of the Bank's asset and liability management which are considered in more detail later in the Chapter.

At the time of the merger of the two banks, Mr Clark and the Board were conscious of the need to properly manage the Bank's assets and liabilities. That appears from the Board Minute approving the charter of the first ALMAC, and from the fact that an asset and liability management committee was in fact formed.

The evidence is that initially the treasury operation of the new bank was a continuation of the dealing operations of the antecedent banks. The Treasury was principally an internal clearing house. If the Bank had an excess of funds it was the role of Treasury to see that the excess was utilised in an appropriate manner. Conversely, if there were insufficient funds it was the role of Treasury to secure the funds that were needed. There was back to back close out of the foreign exchange positions of customers, and short term money market dealings to square the Bank's book at days end. The Bank only had a limited dealing operation. That basic role of the Bank's Treasury has continued throughout.

The Investigation has heard evidence of the respective roles of and interaction between the Treasury and the ALMAC committees in the Bank. A Global Risk Management division was established on 1 July 1989. The relationship between that division, the ALMAC, and Treasury, is also relevant to a consideration of asset and liability management.

While Treasury was clearly responsible for discrete functions, such as managing the Bank's foreign exchange transactions and fund raising, it was not always clear where the responsibility lay for the more general, but much more important, task of overall asset and liability management, or the tasks of managing liquidity and managing the Bank's balance sheet. The evidence is that, at times, these functions were the responsibility of one of the committees; but, at other times, they were left, by default, to personnel in the Treasury, or overlooked.

7.4.1 MR G S OTTAWAY (JULY 1984 - JULY 1986)

Upon the amalgamation of the two banks Mr G S Ottaway was appointed Chief General Manager, Finance. In that capacity, he was ultimately responsible for the treasury operations of the new bank. Mr Ottaway had been the merger manager for the old State Bank, and, together with Mr J B Macky from the Savings Bank, was responsible for the implementation of the merger. Together, Mr Ottaway and Mr Macky produced about 18 manuals containing operating instructions for the new bank; but none of those manuals dealt with asset and liability management or treasury operations.

Neither of the predecessors of the Bank had developed a treasury of any degree of sophistication. The treasury operation of the old State Bank was very limited. Its operations were restricted to managing the liquidity of the Bank and the Reserve Bank account and transacting foreign exchange business on account of customers.() The old Savings Bank had two treasury personnel whose sole role was the management of the funds of the Bank and the management of the Reserve Bank clearing account. They did no trading.()

Before the merger, there was no planning with respect to the sort of treasury that the new bank should have. Mr Ottaway's recollection is that the predominant view was that any determination of the direction the treasury should take was that it should be evolutionary in the sense of being responsive to needs as they were identified rather than planned.()

When asked whether he was responsible for asset and liability management of the Bank Mr Ottaway said: "I can't remember that clearly, but I assume so." () Mr Ottaway's answer is a reflection of the lack of importance that was attributed to asset and liability management at the time the new bank commenced business.

In his evidence to both the Royal Commission and this Investigation, Mr Ottaway said that he was appointed to the one job, for which he did not actually have the experience. He said that he spoke to Mr Clark about his lack of qualifications but Mr Clark assured Mr Ottaway that he had confidence in him.

When the new bank started on 1 July 1984, Mr Ottaway had responsibility for the Treasury, and he reported directly to Mr Clark. Under Mr Ottaway was a Senior Manager Finance, whose responsibilities included the investment of surplus funds and the management of the Bank's prudential assets. This Senior Manager`s department was responsible for recording and settling dealing room transactions. The processes involved have been described to the Investigation as having been "very unsophisticated". The systems used were clerical. The Bank was very liquid. Initially there was no need for the application of sophisticated risk management techniques. The dealing room staff comprised the people who had fulfilled the dealing roles in the antecedent banks. No staff member had experience in a treasury of the size and type that was going to become necessary. The staff were not dealing in the way that term is now understood, but really administered relatively minor positions. At that time, there was no need for a sophisticated treasury operation.

Mr Ottaway said that they "simply set up a 'phone system where they all came to work together and continued substantially to function as they had previously functioned, which was essentially funds management on account of the bank, that is liquidity management, simply making sure that we had enough money to meet the obligations of customers and the investment of surplus funds and the transaction of foreign exchange business on account of customers".() No foreign exchange transactions were undertaken on the Bank's own account. Mr Ottaway described it as a "very simple, very straight forward - essentially riskless business at that stage".() There is no reason to doubt the accuracy of his description. A large proportion of the Bank's funds at that time came from retail deposits from the old Savings Bank. The funding of the Bank was not a problem.

Mr Ottaway was a member of the first ALMAC, but understandably cannot now recall in detail the membership or proceedings at the meetings. He said:

"I know that we started off in a very modest way. As far as asset liability management was concerned my recollections are that we weren't particularly sophisticated about it ...". ()

When asked about the objectives of the first ALMAC, Mr Ottaway said that it tried to see to the development of a balanced portfolio of assets, and overviewed the management of liabilities. As to the effectiveness of the committee, Mr Ottaway said:

"I don't know what an expert would expect of an asset liability management committee so I don't really know. We thought that we were doing an effective job at the time but then as time went on and one learned about the sophistication of organisations that had computer models to help them out and economic reports and as new models were developed, swaps and all sorts of synthetic assets, none of which I personally had knowledge of, one could see that an asset and liability management committee comprised of people with that sort of expertise are going to do something quite different from the sorts of things that we did." ()

Mr Ottaway said that no member of the committee had real expertise in the area of asset and liability management. The members of the first ALMAC were people who, as a result of the merger, were considered to be the best equipped at the time.() Mr Ottaway said that he now knows that the management of a bank's assets and liabilities can be performed in a much more sophisticated way.() Mr Ottaway said "... the whole of the committee really needed to be educated in a quite intense way about something which was entirely new to all of them". He also said that efforts to improve the Treasury operations and asset and liability management were not made "because the organisation was running so fast". ()

So far as the relationship between the Treasury and ALMAC was concerned, Mr Ottaway said that Treasury had a role to play in terms of being responsive to the requirements of the asset liability management committee, but the Treasury was never directly responsible for the overall asset and liability management function.()

Mr Ottaway said that the first ALMAC developed into an interest rate pricing operation, and that pricing was seen as the major function of asset and liability management. He cannot now recall the circumstances surrounding the dissolution of the committee.() He was unable to say who assumed responsibility for asset and liability management on the dissolution of the first ALMAC.()

Mr Ottaway believes there was a consciousness that insufficient was being done in connection with the asset and liability management in the Bank.()

Mr Ottaway's observations provide a telling insight into the origins and development of the Bank's Treasury and asset and liability management. There is a common theme to the evidence and submissions before the Investigation. It is that, at the time of merger, nobody in the Bank knew what was going to be required, and that by the time the requirements were understood, the Bank had grown so quickly, and the business had become so large and changed in its nature so much, that the timely introduction of appropriate systems and procedures had become an almost impossible task.

Mr Ottaway remained in charge of the Finance department and Treasury until 1986.

7.4.2 MR J T HAZEL (OCTOBER 1984 - JULY 1987)

Mr Ottaway was responsible for the recruitment of Mr J T Hazel in about October 1984.() Mr Hazel was engaged because he was perceived to have expertise in the area of treasury operations. He came to the Bank highly recommended. Before joining the State Bank, he had been employed for 10 years in the Australian money and securities market, as head of trading for a merchant bank. He told the Investigation his training and experience was in domestic treasury operations and that he had been responsible for asset and liability management which comprised the funding and management of a loan book.()

He was appointed to head the Treasury and Capital Markets division.() He was given the title of Chief Manager, which was the same title that Mr Ottaway held, although he nominally reported to Mr Ottaway. Although Mr Ottaway was the titular head of the department, the evidence shows that, following the appointment of Mr Hazel, the role of Mr Ottaway became peripheral, and that Mr Hazel was, in fact, the person responsible for Treasury operations. That situation was formally recognised in July 1986, when Mr Hazel was promoted to General Manager, Treasury and Capital Markets.

Mr Hazel described the Bank, at the time he joined, as being totally funded with retail deposits, indeed over funded, to the extent that it had about 40 per cent of its assets in government bills or bonds. He described the systems as largely manual and rudimentary, and said that the staff had little experience.()

Mr Hazel was appointed to the first ALMAC by a resolution of the Board passed on 28 November 1985. He confirmed that "the main concerns of (the first) ALMAC were retail pricing decisions".()

When asked who had the overall responsibility for asset and liability management of the Bank Mr Hazel said:

"When I say ALMAC was pricing, I mean ... that was the primary focus in my view of the meetings we had. ALMAC ... did consider the movement of discrete classes of assets and liabilities and rates on them and we did as time went by consider the impact on likely earnings of the bank of discrete classes of mismatched assets such as the fixed rate lending portfolio which in fact was fully matched by me. So I could say the ALMAC committee had that responsibility." ()

When asked whether he regarded the dissolution of the first ALMAC as an appropriate course, Mr Hazel said that the dissolution of any form of asset and liability management committee in a bank was inappropriate.()

Mr Hazel agreed that, if the first ALMAC had been dissolved without any substitute being put in place, the consequence would have been that the function of overall asset and liability management had been completely abdicated, unless there was a Board direction that the process of asset and liability management was transferred to a line division.() He did not refer to either the passing, or the implementation of, any such Board decision, and did not refer to any substitute for the first ALMAC.

Mr Hazel did not regard himself as being responsible for the overall asset and liability management of the Bank.()

Mr Hazel agreed that the overall management of assets and liabilities was essential. He said that, up until the time that he left the Bank, in July 1987, that function did not receive the attention that it should have. With one exception, he could not recall the directors concerning themselves in this part of the Bank's business.()

During the time that Mr Hazel was in charge of the Treasury, there was no system of cash flow forecasting. Liquidity, however, was never a problem.() Mr Hazel says that he pushed for the introduction of a cash flow forecasting system, but that never happened. He said that the Bank should have had cash flow forecasting in place from the beginning, and believes that responsibility for its introduction was a finance or accounting function.() He says he received no support from the accounting side. He said he raised the matter fairly consistently over his time at the Bank with Mr Ottaway, Mr K L Copley, Mr Clark and Mr S G Paddison.() Mr Hazel said:

"I made the point regularly, ... it was somewhat laughable that, ... an institution like a bank that was assessing credit had no cash flow forecasting ability of its own and that it merely relied on its ability to pick up the 'phone and raise money. It became one of those things, like many things in the bank, that became systems `wish list' items ...". ()

It was his view that most of the people in the Bank dismissed treasury operations as something they did not understand.()

Towards the end of his period in the Treasury, Mr Hazel arranged for Ms J A Meeking to be employed to further the systems development. At that time, the Treasury did not mark assets or liabilities to the market, and there was no system of transfer pricing. Mr Hazel said the impetus to introduce transfer pricing had come from Mr Clark who "intimated to me from the very beginning that he wanted Treasury to be a separate profit centre".()

Mr Hazel agreed that the considerations which required the implementation of transfer pricing when he left the Bank in July 1987 had existed at the time he started in Treasury in 1984.()

As to the reason for the delay in the introduction of transfer pricing, Mr Hazel said:

"I guess ... whoever commissioned the accounting system and general ledger package for the Bank commissioned a system that was not adequate to do what it should have done so [as] somebody who came after merger to run a treasury I was confronted with an accounting package that certainly could not do the rudimentary things that I would have wanted it to do." ()

Mr Hazel agreed that if a bank is growing quickly it needs a platform on which to grow and if it cannot get its treasury operations in order it will have a real problem.() Notwithstanding the acknowledged deficiencies, however, Mr Hazel said that no actual problems were experienced "on the treasury side of the Bank" during his time in the Treasury of the Bank.

Mr Hazel said that if the Bank had developed better asset and liability management systems it could have priced liabilities better, and therefore have had a more adequate view of pricing loans.() His solicitors subsequently submitted that in giving that evidence it was Mr Hazel's intention to show that, in theory, the Bank may have modified its dealings in the lending area from a pricing point of view, but in practice, such modification would not have had any great impact; because the Bank priced according to the market.()

Mr Hazel also gave evidence that the absence of appropriate profit centre reporting threw doubt upon the profits which the bank was reporting.() Mr Hazel said that Mr Clark "drove sales and assumed that ... the margin was spread over a cost of funds or assumed if you had sales, you would earn profit. One of the things he forgot over time is a need for provision ... out of current revenue. But his emphasis was on sales, not on ... profit centre reporting or correct allocation of cost".()

Mr Hazel said that "the lack of attention to systems ... enabled people to manipulate the situation", and that "... if the systems are not in place to match revenue and expense then ... it is a question of working out what increases the profit you are reporting." ()

The structuring of loan transactions to include disproportionate front end fees was a commonly used device which had the effect of increasing reported profit in the short term.() Transactions were structured so that an unduly large fee was obtained by the Bank at the commencement of a loan, with a corresponding reduction in the interest charges to be paid over the duration of the loan. The practice has the effect of increasing the reported profit of the Bank in the first year of the transaction to the detriment of subsequent years. Mr Hazel said he succeeded in having the Board pass a resolution to the effect that all fees should be amortised over the life of the facility, but that policy was later reversed.()

At no time did Mr Hazel, or the Treasury, play any part in the pricing of transactions which were being entered into by the wholesale banking division of the Bank.()

When Mr Hazel moved to become Managing Director of Ayers Finniss in July 1987, his position as Chief Manager Treasury and International was taken by Mr T L Mallett. Concurrently the Bank was in the process of employing Ms Meeking. Because Mr Mallett had no experience in the treasury of a bank, Ms Meeking's position was restructured to something bigger than had been initially contemplated.()

Mr Hazel said that, at the time he left Treasury, the procedures and systems and policies were lagging desperately.() He said that he was uncomfortable trading in sophisticated instruments without having procedures and policies in place to deal with them.() He said that people in Treasury fought, and eventually got the systems in place, but, at the end of his time, they were still incomplete.() Mr Hazel said that, if he had his time again, he would try to achieve a better balance between the operational side and the systems side.() He said he would have dealt with the matter sooner and that he would have hired more people on the accounting systems side in preference to the dealing side.() He said:

"With the benefit of hindsight I think [that with] the growth of the Bank that occurred ... we should have taken a much earlier and [more] aggressive approach to systems development than we did ... [The Bank] did not grow in terms of systems development as it should have." ()

He also said:

"... the emphasis was on growth and profitability. I certainly was surprised continually by the rate of growth that was undertaken and achieved and it certainly outstripped any plans that I saw, and certainly, from any personal point of view, had I known the growth would be of the order undertaken, then it would have been appropriate to have put a lot more effort and time into making sure that the systems and procedures kept up with that growth." ()

Mr Hazel attributed the inability to introduce "things like transfer pricing and cash flow forecasting" to a degree of hesitancy on the part of other senior bank employees.() He said he had discussed those matters and the reaction he received was:

"... there was just a lot of `gonna' about it over that period. I think it was the same case, where you had a reasonably competent finance man with no staff who were any good underneath him, totally swamped by the needs or the requirements of the job." ()

Mr Hazel described his role in the Bank, at the time he went to Ayers Finniss, as one of "liquidity management and wholesale funding".() He confirmed that the first ALMAC had become a pricing committee.() He also confirmed that pricing was not carried out by reference to the cost of funds, but by reference to market considerations.()

Mr Hazel's evidence indicates that because of the practice of pricing wholesale lending against market forces rather than by reference to the cost of funds, a culture was being established for lenders in the Corporate Banking division to have little regard to the cost, or liquidity characteristics, of the funds which were being utilised by the transactions which they were entering into. The absence of the discipline of considering the cost and liquidity characteristics of funds meant that there was an opportunity for transactions on which there was either minimal profit, or no profit, to be entered into without recognition of that fact. In my opinion, if there had been an appropriate system of transfer pricing, and the practice of giving due regard to the cost of funds when structuring lending transactions had been developed it is probable that the rapid asset growth which occurred in later years would have been curtailed.

At the time Mr Hazel left Treasury there was no cash flow forecasting system. Accordingly, there was no information base against which an assessment could be made about future liquidity requirements. Nevertheless, throughout the period Mr Hazel was employed in its Treasury the Bank was quite liquid and the absence of cash flow reporting did not give rise to any practical difficulty.

The absence of a cash flow forecasting system and proper liquidity management became matters of practical importance in later years. The need for a cash flow forecasting system had been recognised by Mr Hazel, and his recognition of the need should have provided a sufficient impetus for appropriate action to be taken. Whether a cash flow forecasting system was not introduced because of apathy, or because of active resistance, does not matter. Cash flow forecasting was carried out in other financial institutions, and the need for cash flow forecasting had been recognised in State Bank. For the business of the Bank to be conducted in accordance with the principles of sound financial management, a system of cash flow forecasting should, in my opinion, have been introduced no later than the time at which Mr Hazel recognised its need.

During Mr Hazel's time in Treasury the bank was under geared. It had the benefit of the government guarantee and a triple AAA rating. Understandably, it had no difficulty in obtaining funds. Mr Hazel said that the initial growth of the Bank's balance sheet was funded by retail deposits.() I infer from the evidence that the relative ease with which the Bank could secure funds contributed to a complacency with respect to the importance of asset and liability management.

At the time Mr Hazel left the Treasury, the foreign exchange dealings were carried out on a Kapiti software system. The system is a treasury system which includes a multi currency general ledger. The Kapiti system had still not been developed to its full extent. The Bank had no system for money market or capital market instruments. Those transactions were recorded in registers and spread sheet programmes, and reliable information with respect to maturity structures, current valuations, and performance of assets against market bench marks, was unavailable.

On the whole, Mr Hazel's evidence shows that when he left the Bank in 1987 the systems, policies and support staff were inadequate and underdeveloped. There was then an immediate need for systems and procedures to be introduced and for other shortcomings to be remedied. That need had, in part, been recognised, and it was for that reason that Ms Meeking was employed.

When asked about the liquidity policy during his term in Treasury, Mr Hazel said:

"There was clearly a policy of dealing with liquidity that came out of the banks that formed the State Bank." ()

and

"... what we had in place at the time I was in the chair was Board approved and was simply adherence ... to the Reserve Bank guidelines on the matter." ()

But, the existence of a policy is one thing, and compliance with the policy is another. With no system of cash flow forecasting in place, meaningful compliance with a liquidity policy would have been most difficult. This Investigation has not heard any evidence that the Bank had in place, at this time, systems and procedures to manage its liquidity in the way described in Reserve Bank Prudential Statement D1.()

Mr Clark has submitted that, if the Treasury procedures system and policies were lagging at the time Mr Hazel left the Bank, then that was primarily Mr Hazel's own fault. Mr Clark acknowledged that Treasury operations were not his area of expertise, and says that it was for that very reason that he appointed Mr Hazel to head the area. According to Mr Clark that Mr Hazel had "put himself forward as very knowledgeable in the Treasury area", and was appointed as an expert to bring this area under his control and develop it. Mr Clark submitted that "By his own admission he failed." ()

This submission of Mr Clark is discussed, in the context of other evidence, later in this Chapter.

7.4.3 MR T L MALLETT AND MS J A MEEKING (MAY 1987 - NOVEMBER 1990)

Mr Hazel's successor was Mr Mallett. Mr Mallett had commenced employment with the Bank in November of 1984. From that time, he held various positions until May of 1987 when he was appointed Chief Manager, Treasury and International.

Mr Mallett had no previous experience with treasury operations in either the State Bank or any other bank.() At the time of his appointment to Treasury, Mr Mallett already had a full time job as Chief Manager, International. Mr Mallett said that "I did not have that experience and I suppose with the real benefit of hindsight ... it looked stupid for someone who had a full-time job running International Banking to suddenly be given another job which someone had been at full-time before and merge the two together." ()

Mr Hazel spoke to Mr Clark against Mr Mallett's appointment, but Mr Clark still went ahead.

In Mr Mallett's terms, the concept was that "I would just take Jim Hazel's responsibilities as treasury and take them, as it was, under my wing with the key staff that he had at that moment in time".() While Mr Mallett acknowledged his lack of experience in treasury operations, he believed that he was appointed to the position in Treasury because of his strengths in management.()

Almost concurrently with Mr Mallett's appointment as Chief Manager, Treasury and International, Ms Meeking was appointed to the position of Senior Manager, Money Market. Ms Meeking has a strong academic background. She holds a Masters Degree in Business Administration, and a Bachelor of Arts Degree. She also had practical experience in treasury operations, having managed the Treasury and Foreign Exchange activities of the merchant bank Michell NBD Ltd, and having worked as Manager, Treasury, with Adelaide Steamship Co Limited.

It was at about the time that Mr Mallett was appointed Chief Manager Treasury and International, that the first ALMAC was dissolved. Mr Mallett was unable to recall whether he was involved in the decision to abandon the first ALMAC, and has no recollection of attending any of its meetings.()

Ms Meeking says that when she joined the Bank, there was no general ALMAC. Her belief was that the first ALMAC had been no more than a retail pricing committee.()

The weight of the evidence is that there was not at this time, any person or committee which was formally vested with responsibility for the overall general management of the Bank's assets and liabilities. Certain discrete tasks relevant to asset and liability management functions were carried out in Treasury, but it was not the role of Treasury to take an overview of the Bank's position. Indeed, the evidence shows that, because of the lack of appropriate systems, and because of the fact that there was no flow of relevant information into the Treasury, it would not have been in a position to take an overview of the Bank's position in any event.

At this time, the Bank was growing rapidly. Mr Mallett testified that, the Board demonstrated no concern to ensure that an appropriate infrastructure was put in place to support the growth.()  Mr Mallett said that he was not aware of any decision or initiative of the Board which related to the management of the Bank's balance sheet.()

He said that he had mistakenly assumed that the Board members had a better understanding of the subject than they, in fact, did.()

Mr Mallett was in charge of the Treasury from July 1987 to October 1989. Throughout that period, Ms Meeking held various senior positions in Treasury. She started in July 1987 as Senior Manager - Money Markets, and remained with the Bank until November 1990. For most of the time, her position was Chief Manager, Treasury and Capital Markets.

While Mr Mallett did not have a detailed knowledge of the operational aspects of Treasury, Ms Meeking did have practical experience of what was required at that level. Her area of responsibility, however, was confined to treasury operations, and did not extend to the more general asset and liability management.

Ms Meeking said that the staff in Treasury, at the time she commenced, were, with one or two exceptions, "old State bankers" and that they "really lacked a lot of experience". She contrasted them with the persons she recruited subsequently whom she described as "performing extremely well".()

Mr Mallett agreed that the operational staff in Treasury were generally underskilled, and lacked appropriate experience by reason of the fact that the Bank was located in Adelaide. He said:

"It was extremely difficult in a changing market, with home grown staff in the whole bank to keep everyone up to speed. You had to - it created risks of its own - but you had to bring in people who again had the experience you wanted in other markets with other employers." ()

Ms Meeking did not have a formal job description, but she set herself a number of objectives. They included:

(a) to introduce transfer pricing throughout the Bank;

(b) to introduce a system for marking the Bank's Treasury portfolio to market;

(c) to ensure that Treasury had a balanced balance sheet; and

(d) to develop cash flow forecasting.

The uncontradicted evidence is that Ms Meeking worked in a determined fashion to achieve these objectives. Ms Meeking told the Investigation that she had the agreement and support of Mr Mallett. She said that she encountered opposition from other senior executives in the Bank including Mr Paddison, (who was at that time General Manager of the Retail Bank) and from the Finance department, (in particular Mr Copley).()

The first three of the objectives which Ms Meeking set were adopted, in principle, during the time of her employment; although a report following a review of the Bank's Treasury Risk Management policies and practices by KPMG Peat Marwick Hungerford, in September 1989, ("the Peats Report")() and the evidence of Mr S C Targett, which are referred to later reveal that a degree of refinement in the systems was still required. At the time she left the Bank, there was still no cash flow forecasting system.

Ms Meeking also gave evidence that she argued with Mr Copley about the matter of cash flow budgeting (her term for cash flow forecasting or cash flow reporting), and that, at an executive meeting at the end of 1988, Mr Clark instructed him to put cash flow budgets in place, but it just did not happen.()

Mr Mallett said that the Finance department had the responsibility for introducing cash flow forecasting, but they never managed to achieve it.() He said Mr Copley's attitude towards the introduction of cash flow forecasting was that it was too hard, and could not be done, although he did say that Mr Copley was not opposed to its introduction. He also said that Mr Copley was opposed to marking to market.()

Ms Meeking was instrumental in having a software package which became known as "Heaven", developed internally. Her initiatives in that area were opposed by Mr Macky, who was, as Chief Manager, Information Systems, in charge of the Information Systems department at the Bank.() Mr Copley also opposed the development of the software. He holds the view that it was not appropriate for the Bank to commit resources to the development of software, because a better alternative would have been to acquire a package which had been already developed. That view is shared by other persons who have given evidence to the Investigation.

Ms Meeking told the Inquiry that those persons who were opposed to the development of the Heaven software did not understand the intricacies of the transactions, and the trading risks and opportunities inherent in the Structured Finance portfolio for which the Heaven software was primarily developed. She said that before commissioning the in-house development of Heaven she contacted several financial institutions with similar businesses, but was unable to locate an existing package which suited the needs of the Bank.()

Following the departure of Ms Meeking from the Bank, the Heaven system has been developed extensively and is now universally acknowledged to play an important role in the treasury operations of the Bank.

The absence of transfer pricing, and a system for marking assets to market, meant that it was not possible to measure divisional profitability. At the time Ms Meeking started in Treasury, if Treasury borrowed funds on behalf of the Bank to fund advances made by an operating division such as Corporate Banking, the asset, namely the advance to the customer, was recorded in the books of Corporate Banking, but the liability in respect of the funds borrowed by the Bank was recorded in the books of Treasury. As a consequence, Treasury incurred a notional divisional loss to the extent that it was debited with the cost of interest and other charges on the liabilities raised to fund Corporate Banking. Corporate Banking, on the other hand, derived a notional benefit to the extent that the revenue generated by the asset, was credited to Corporate Banking. The result of this method of operation was that the greater the business written by Corporate Banking, the greater the reported divisional profit of Corporate Banking, and the greater the divisional loss of Treasury. Not unnaturally, this situation created a belief within the Bank that the Treasury operations were unprofitable. Ms Meeking was concerned that the effect of the absence of a balanced balance sheet may not have been fully understood by senior management of the Bank, and that the criticism that the Bank's Treasury was unprofitable was unfounded.

Ms Meeking said:

"... the treasury and capital markets division, which came to be called just the treasury division, was ... regarded as the black hole in that it never had a balance sheet as such. It was just the ebb and flow of what was left at the end of the day after various parts of the Bank spent money and received interest and received deposits and so on." ()

Mr Mallett also described Treasury at the time he assumed responsibility for Treasury as "a black hole". He said:

"When I took over Treasury I did not understand the dynamics of my P&L because it was just too confusing." ()

From a management information perspective, the failure to cost the price of funds used to service transactions, together with the absence of a system for transfer pricing funds flows between divisions, made it impossible to accurately monitor divisional contributions to profit. Ms Meeking said that fact was not understood in the Bank. In particular, she said that fact was not understood by Mr Clark.()

Ms Meeking gave evidence that, in about August 1988, (when a basic form of transfer pricing was first introduced), the information available to her omitted all reference to the management of the treasury risks of the organisation(), and that she had a real concern that the Bank itself just did not know where it stood.() Ms Meeking said that the Board and senior management did not understand that there were deficiencies in the reporting of profit. She believes that the Board "always assumed there always was transfer pricing in place". She said:

"I think the Board certainly did understand, after we put in place transfer pricing, who was profitable and who was not at least in terms of gross margin, before the allocation of overhead costs such as Finance Department, Information Systems, some personnel costs etc. I don't think they understood before it was put in place that there was no transfer pricing, and that therefore the reporting was defective." ()

Ms Meeking gave evidence that part of the problem was the way in which the Finance department reported the performance of Treasury prior to the introduction of transfer pricing. She said the reports gave the impression that Treasury was a reportable entity when the figures were, in fact, meaningless. It is her view that to report such figures did more harm than good.()

Ms Meeking said that when an appropriate system of transfer pricing was introduced, and Treasury achieved a balanced balance sheet, it became apparent that the Treasury of the Bank was, in fact, profitable. In addition, it eventually became possible to obtain a more accurate understanding of the profitability of the operating divisions of the Bank, and the profitability of particular transactions. The consequences of the ability to measure profitability in this way are important to the conclusions which I have reached, and they are discussed in more detail later in this Report.

Ms Meeking gave evidence that, at the time transfer pricing was introduced, Treasury was given a balanced balance sheet by the use of what became known as the Liquidity division. By the use of that accounting device, cash outflows which could not properly be attributed to Treasury were debited against the Liquidity division. The result, therefore, was that, while Treasury may have had a balanced book, the Bank as a whole was still not managing its assets and liabilities. The Liquidity division was also described as a "black hole".()

Ms Meeking gave evidence that the Bank had transfer pricing in place by the time Mr Targett arrived at the Bank. Mr Targett arrived in Adelaide in October 1989. She claimed the credit for the introduction of the system of transfer pricing. She said:

"... I always saw the program that I started in Treasury when I started at the Bank as being a three year program and I always saw it in terms of getting the systems in place, I suppose getting the policy agreement in place at the Bank - getting the systems in place, the transfer pricing in place and then sorting out the people and getting them in place." ()

During the time Ms Meeking worked in the Bank's Treasury, Retail Banking was an independent operation and had its own asset and liability management committee which made its own pricing decisions. Ms Meeking said Mr Paddison opposed the introduction of transfer pricing which would have had the effect of charging an administrative overhead to the Retail Banking division of which he was the head. Ms Meeking gave evidence that the profits reported by Retail Banking were misleading, because overhead expenses such as the cost of personnel, computing, imputed rent etc, were not attributed back to Retail Banking in the Bank's profit reporting. The introduction of a proper transfer pricing system in conjunction with arrangements to allocate the costs of the infrastructure would have shown up the true position.

Later Ms Meeking acknowledged that it was inappropriate to single out the Retail Banking division, and that her comments about the reporting of profit were of equal application to the other operating divisions of the Bank.() Mr Paddison's response to Ms Meeking's evidence is considered later in this Chapter.

In April 1988, Ms Meeking's role was expanded and she became Chief Manager, Treasury, with responsibility for foreign exchange. She had responsibility for the local or Australian Treasury but not the International Treasury or capital markets. In December 1988, Ms Meeking took two months leave and Mr Targett, who was, at the time, the Treasurer of the Bank's branch in London, acted in place of Ms Meeking.

After the restructure into Australian banking and International banking divisions and the consequent division of Treasury operations, Ms Meeking became responsible for the International Treasury as from April or May 1989. Her duties were largely confined to raising funds in off-shore markets. From that time to the end of the period under review, Mr Targett played the dominant role in the Bank's Treasury operations. The International Treasury position to which Ms Meeking moved was, in her view, a significantly less responsible position than her prior position as Chief Manager, Australian Treasury.

Ms Meeking gave evidence of her disappointment in having to hand over the Australian Treasury at the time she did. She said that she felt as if she had done all the ground work which had, in many respects, been a very thankless task, and that she handed the operation over to Mr Targett, who continued the work which she had started, and then took the credit for it.() She said:

"... When I left Australian Treasury, it still needed a lot of work as far as ... the people went and as far as ... making it perform but that the ground work had been put in place." ()

A second Asset and Liability Committee was established in September 1988. It is Ms Meeking's view that the second ALMAC became increasingly effective during her time at the Bank. She also said that the Committee did not enjoy "the sort of board direction or involvement or understanding that might have been desirable".()

Ms Meeking said that when the second ALMAC started meeting, much time was taken up with trying to get basic information, such as maturity profiles, out of Retail Banking. Ms Meeking also believes that the overall liquidity management and liability management had been hindered by the political ambitions of divisional heads, and that it was only when Mr Paddison was put in charge of both the lending and funding divisions (Corporate Banking and Australian Treasury) that fundamental issues, such as asset and liability management which required a bank wide approach, made progress.()

Ms Meeking also has the view that, by the time she left the Bank, the systems were "very adequate" and Treasury was no longer underserviced by the systems it then had in place.()

Ms Meeking gave evidence that the overall asset and liability management and the management of interest rate risk, liquidity risk, and foreign exchange risk "were not being managed very adequately at all".() She agreed that the whole asset and liability management of the Bank, and the treasury operations of the Bank, were fragmented. She said Treasury was not in a position to take an overview "because the Retail Bank was adamant that it didn't want its portfolio managed by the Treasury division". She believes that it should have been the Treasury department which carried out that task. Ms Meeking acknowledged that it was important that somebody should have taken an overview, and have ensured that the asset and liability management function was conducted in an appropriate function.()

Mr Mallett said that when the second ALMAC was formed was the first time that the Bank undertook a more formal consideration of the balance sheet as a whole. When it was suggested to Mr Mallett that, up until the time of the establishment of the second ALMAC, the overall management of the Bank's balance sheet and an overall asset and liability management function was something which was not really given consideration in the Bank, he said:

"It would be unfair for me to say that it didn't exist or wasn't under consideration because it could have been and I was not aware of it. I was not aware of any major exercise that co-ordinated the Bank's balance sheet as a whole." ()

Given Mr Mallett's position as Treasurer, the proposition that somebody else may have had responsibility for the overall management of the Bank's balance sheet and overall asset and liability management function without the Treasurer being aware of that fact is incredible. There is no evidence before the Investigation that there was any overall co-ordination of those functions and the only conclusion open to this Investigation is that the task was and had been ignored by the Bank. Mr Mallett said that he was not aware of anybody who sat on top of the different areas and asked "If you are projecting that level of asset growth how is it going to be funded".()

The totality of the evidence is that throughout this period, overall asset and liability management remained largely ignored.

The evidence shows that significant improvements were made to the Bank's Treasury operations and certain components of asset and liability management while Ms Meeking was employed by the Bank. While there were still further improvements to be made, it could not be suggested that they were a consequence of any shortcoming on the part of Ms Meeking. As was to be expected, Mr Mallett did not have the background to enable him to make a significant contribution to the introduction and implementation of the systems and procedures that were lacking or deficient, but he did support Ms Meeking in her initiatives.

I am satisfied that when Ms Meeking left the Australian Treasury, it was operating much more effectively than when she took over, but there was still much to be done. The fact that there were still problems within the Treasury is evidenced by the circumstances surrounding the recruitment of Mr Targett, and by the report of KPMG Peat Marwick Hungerfords (which is referred to below.)

When Ms Meeking left the Bank, in November 1990, the International and Australian Treasuries were consolidated.

7.4.4 THE REPORT OF KPMG PEAT MARWICK HUNGERFORDS (SEPTEMBER 1989)

During August and September 1989, KPMG Peat Marwick Hungerfords conducted, at the Bank's request, a review of the Bank's policies, controls, procedures, and systems, for the management of treasury risk, with particular emphasis upon the Australian Treasury. A report dated 29 September 1989 ("the Peats Report"), setting out the results of that review was forwarded to Ms M Chin, Senior Manager - Internal Audit.

The report observed that there had, over the previous few years, been a dramatic change in the nature and scope of the Bank's wholesale banking activities, in that wholesale banking had progressed from a position where it was insignificant to a position where it represented the greater part of the Bank's business. The authors of the report expressed the view that, while that change had presented a major management challenge, "management" had responded to the challenge effectively. Nevertheless, the conclusions in the report identified many areas where the Bank could improve its asset and liability management and treasury activities.

Importantly, the report pointed out "a need to clarify the respective roles of Global Risk Management, Asset and Liability Management Committee ("ALMAC") and the individual business units as there are varying perspectives on the relationship between these two groups within State Bank".() The report suggested what the respective roles should be.

The report observed that the existing treasury systems did not adequately support the Bank's treasury activities, and that many of the other matters of concern identified in the report were, at least in part, attributable to that lack of support.()

An important observation made in the report was that there were no formal policies addressing control over the Bank's liquidity risk. The report recommended that research into liquidity risk be undertaken, and that a formal policy be established.()

The report stated that while the Bank had made considerable progress in implementing a system for transfer pricing between divisions, and between units within each division, there were still shortfalls in the system.()

The report observed that operational staff were inexperienced with the greater proportion having less than twelve months' experience(), and recommended that the level of experience be increased by external recruitment, particularly to address what was considered lack of mid management expertise. Training courses and the encouragement of staff retention were also recommended.

The report pointed out that, because of the limitations of the Kapiti system, accrual accounting concepts were adopted for all areas of Australian Treasury with the exception of foreign exchange. The report recommended that industry practice, namely a mark to market approach, be adopted.()

The report suggested that a complete review be undertaken of the way the Kapiti system was being used.() The report observed that the systems used to process Australian Treasury transactions were based around the Kapiti system, and failed to adequately fulfil the Bank's needs. The report was unable to identify a clear direction or a strategic plan for future development. It recommended that a Treasury Systems Steering Committee be established consisting of senior management and systems representatives from Australian Treasury and International Banking, and that it be charged, amongst other things, with responsibility for identification, prioritisation, and co-ordination, of treasury system needs for the Group, and the development of a medium term and long term strategic plan for the Bank treasury systems.()

Other recommendations made by the report included the clarification of responsibilities by:

(a) revising the charters of Global Risk Management and ALMAC to emphasise Global Risk Management's prescriptive policy role and ALMAC's strategic focus;

(b) establishing limits for the risks under management by ALMAC;

(c) expanding the scope of ALMAC to include the full State Bank Group;

(d) assigning responsibility for macro currency and liquidity risk management to ALMAC; and

(e) establishing policies which defined when policy and limits needed to be referred to the Executive Committee for approval.()

It was suggested that controls be increased to ensure policies were enforced. In particular, it was suggested that transfer pricing calculations should include interest received and paid, that the risk management book be marked to market, and that options for marking to market other positions be investigated.()

The Peats Report is objective contemporaneous evidence that there were significant fundamental deficiencies in the asset and liability management and treasury operations of the Bank as at September 1989.

The Directors have submitted that they were never provided with a copy of the Peats Report.

7.4.5 MR S G PADDISON (JULY 1989 - 1991)

Mr Paddison's background was a management information systems consultant. His experience was focused towards banking systems. He was working as a consultant when he became involved in the installation of a general ledger system within the Bank. He impressed the senior management of the Bank, and was offered employment which he accepted. He worked in a number of senior positions in the Bank, and, upon the restructure of the Bank into two divisions in July 1989, took over responsibility for the Australian Treasury from Mr Mallett. Like Mr Mallett, Mr Paddison had no prior experience in the Treasury of a bank. He told the Investigation that the lack of practical experience was a handicap, and that he was very dependent upon the quality of the people he had working for him.()

When Mr Paddison took over responsibility for the Australian Treasury operation he was promoted to the position of Chief General Manager of the Australian Banking division. At the same time, Mr Mallett was promoted to the position of Chief General Manager, International Banking. Upon the restructure of the Bank, the Treasury was split. Mr Targett became Treasurer of the Australian Treasury and Ms Meeking became Treasurer of the International Treasury. Mr Targett reported to Mr Paddison and Ms Meeking reported to Mr Mallett. In addition to the two Treasuries in the Bank, Beneficial Finance Corporation Limited conducted its own treasury and Retail Banking still performed certain treasury functions. Also, by this time off-shore Treasuries had been established in London, New York, and Auckland and they reported to the managers in the countries where those treasuries were based, and then to Mr Mallett.

Although Mr Paddison was ultimately responsible for the Australian Treasury and subsequently the combined Treasury, his involvement in the day to day activities of Treasury was minimal. It was Mr Targett who was principally involved with treasury operations. Mr Targett gave evidence that Mr Paddison supported him in his initiatives and activities.

Mr Paddison said that, during the middle of 1989, asset and liability management was really the responsibility of individual business units.() He described asset and liability management as:

"... the management of the embedded interest rate risk in the bank's balance sheet relating to the understanding of the term structure of the assets and liabilities on both sides of the balance sheet, and the extent to which that embedded term structure creates interest rate funding or liquidity risk ... and you have currency risk ...". ()

He said that, in his experience, banks differ in the way they organise the asset and liability management function, but that most banks "do have some form of ALCO (asset and liability management) committee which normally operates at a more macro level" and that "in general one would expect funding and liquidity management to be part of the operations of treasury".()

He agreed that it was important that there should be somebody within the Bank who could take an overview of the asset and liability management of the whole State Bank Group. He said there were advantages for both centralising the function and managing it on an individual basis but that "one of the key advantages in having a centralised overview is that individual business units can have offsetting risks positions and only by pulling the total picture together can you see if you are in fact adequately hedged ... business unit to business unit as within the totality of the balance sheet ..."()

He said a major handicap to obtaining a global view of the situation in the State Bank was the inability to collate the necessary information "because many of the systems were developed specifically for the particular business unit and most of them are based functionally around ... lending and they were not designed with the intention of throwing liquidity related information out as a by product of the system".()

Mr Paddison says that the Bank had not formulated a liquidity policy until late in 1990.() Mr Paddison said that when Mr Targett took over the Treasury "there had really been no structured approach to domestic liquidity and funding management, mainly because the markets were so liquid for a Government institution with our credit rating". ()

The importance of a liquidity policy is demonstrated by the following evidence of Mr Paddison:

"In terms of liquidity I think that if the work that was done in Australian Treasury, and particularly the work that was done in late 1990 had not been done, our ability to manage the funding liquidity position of the Bank when the bank's earnings announcement was made in February 1991 would have been very difficult".()

Mr Paddison did not accept the previously held view "that if you were a AAA rated government bank liquidity was almost unlimited in the Australian market ".() He said:

"I certainly had the view that that might change and we had quite a significant investor concentration ... four or five major investors provided a lot of our short term liquidity. My concern was that if we lost those lines that our short term liquidity position could become quite difficult quite quickly".()

Mr Paddison said that when Mr Targett started at the Bank the first priority was the long dated interest rate risk management and swaps management. Those functions were transferred to a specialist team that was recruited in Sydney. The second priority was funding management and liquidity management. He said "Steve Targett started really reflecting to me his view that you could not actually manage that sort of risk unless you managed it on a global basis". ()

Mr Paddison says that he and Mr Targett sensed that a liquidity crisis was a possibility and that "basically we worked with International banking to lengthen the maturity profile of the Bank's funding as much as was possible, and we probably spent the last two months (of 1990) and all of January (1991) getting on board as much short term liquidity as we could. We basically over-borrowed the book as much as we could". ()

A growing awareness in the Bank of the importance of liquidity to asset and liability management is demonstrated by the following evidence of Mr Paddison:

"I cannot recall the exact chronology, but out of the work that ALMAC did, and after a number of false starts, we recognised that although ALMAC's original charter was really focussed on the term structure of the balance sheet and the embedded interest rate risk, that in actual fact what was a more pragmatic practical issue was really liquidity and funding structure. And in that sense I would have to say my own understanding of the area ... was maturing quite sharply at the time." ()

The interest of Mr Paddison in the area of asset and liability management was enhanced by his attendance at a seminar conducted by a company which sold a software package called Sendero. He said:

"I realised that relatively speaking our appreciation of the complexity of that interest rate risk was not very strong ... but most importantly I started to understand just how sophisticated interest rate risk management really was." ()

Mr Paddison said "and we then ... started going down the path of making it happen practically" and that "the more you work at the policy level the more your realise that it is no good having the policy unless you have got operational systems to make it happen." () He said it became a two stage project, and that the first stage was to get "the global picture"; but there were difficulties with respect to that because of the independence of Beneficial Finance. He said an awareness developed that the Bank "just did not know what Beneficial looked like" (), and that the funding of Beneficial Finance was one of the matters which could affect the liquidity of the Bank. Mr Paddison said "I think that if we had started two months later we could have run into problems" by reason of the fact of "Just not being organised to know what the funding requirements were and not perceiving early enough of the need to lengthen our funding profile as much as possible and get as liquid as possible prior to the earnings announcement." ()

From this evidence of Mr Paddison, it is clear that, at the end of 1990, the Bank was rapidly developing an acute awareness of the need for proper management, on a Group basis, of assets and liabilities and liquidity, and that steps were at last being taken to put into effect procedures and policies which should have existed since the time when the Bank commenced its operations.

Mr Paddison gave evidence about the development of a "commitment register". He said the commitment register was primarily concerned with credit information, but as a by product, produced "a lot of liquidity information". The commitment register is now the core of the Bank's credit rating system. Mr Paddison said:

"... the commitment register was an important part of carrying information that was essential for liquidity because ... the lending systems did not have particular information about a lot of the things like undrawn commitments ..." ()

Mr Paddison gave evidence that there was no co-ordination of the different treasury systems in use in the Group. He said:

"Beneficial had a thing called FRS. ... there was Hogan in the Australian Bank, there was FRS in Beneficial, there was Midas in Auckland and there was Kapiti in New York and London. So you had virtually almost a complete separate system in every location and even some of the lending systems did not generate good - funding interest rate risk management capability." ()

He also said that, the ALMAC software, both the Chase model and the Sendero model, were operated on a personal computer which "just was not able to handle the volume of different data which we were trying to stuff into it."

Although the Bank did have an Information Systems division, Mr Paddison did not think that division was able to co-ordinate the Bank's activities because "if your business people with the functional experience do not have the time and do not have the dialogue with the computer people, all you get is an automated mess." () He agreed that, in general, there was a deficiency in the Bank in that there was nobody standing above the separate divisions taking an overview and co-ordinating the different activities.() When asked who should have been taking that overview, Mr Paddison suggested that each of the asset and liability management committee, the Board of Directors, the Executive Committee, and the Chief Executive, had a responsibility which he was not able to divide.

It is Mr Paddison's view that the Bank's rate of growth was too fast, but that fact was not recognised at the time.() He said:

"What did not happen is that the policy framework was not there for someone to say; we are not comfortable with that, we want some deliberate policy limits in place that constrain the rate of growth." ()

He said:

"... the rate of growth well outpaced the ability to evolve systems, training, and skills, and the growth was running faster than the ability of people to build skills and knowledge." ()

He said that matter was recognised in the sense that it had been noted but that the recognition did not turn into something more substantial. He said:

"... by the time the perception that the rate of growth and the lack of system consolidation had got to the point where people were starting to say; we must do something about them, the problems were starting to roll at such a pace that the Board and most of the senior management team were totally consumed with firefighting." ()

Mr Paddison gave evidence that, by April of 1990, there was a growing perception that all was not well in Beneficial Finance.

Mr Paddison said that, by November 1990, relationships between Mr Clark and the Directors had almost disintegrated, and that the Directors "were getting pretty shellshocked because of the New Zealand activities of the Bank and Beneficial Finance." ()

Mr Paddison could not remember whether he played any part in the first ALMAC, although he said "it is gracing it a bit to call it an ALMAC. What it really was [was] a glorified pricing committee that really focussed on retail banking pricing".() His belief is that the first ALMAC was disbanded at about the time he took over Retail Banking as a "by product" of a process whereby Mr Clark "changed his structure and management approach and placed a lot more emphasis on individual decision making." () He also said "ALMAC in the sense that we have it now was certainly not ALMAC as I recall it back in '86".()

The minutes of the first ALMAC, which have been made available to the Investigation show that Mr Paddison did attend meetings, at least from meeting No 79 on 14 January 1987.

Mr Paddison said that the re-establishment of an ALMAC was a consequence of his own increasing awareness of the importance of asset and liability management following his attendance at the Sendero seminar. He agreed that, notwithstanding the formation of the second ALMAC, it was probably not until 1990 that there was anybody who stood back and took an overview of the Bank's asset and liability management as a whole.()

Following Mr Paddison's attendance at the Sendero seminar, arrangements were made for a representative of the Sendero company to conduct an internal seminar for the Bank on 16 March 1989. The title of his address was "Responsibilities of Directors and Senior Managers for understanding and measuring interest rate risk". The list of proposed attendees at the meeting included Mr Copley, Mr Mallett, Mr K S Matthews, Ms Meeking, and Mr Paddison but did not include any of the Directors. Following that seminar, a meeting of the second ALMAC was held on Wednesday 29 March 1989. The minutes of that meeting note:

"A decision was made at the last Asset and Liability Management meeting for the Committee to fully revisit its purpose and objectives particularly following the Sendero presentation by Cliff Myers. This revisit will provide us with an opportunity to start the thought process again on how the Bank handles its commitment to Asset and Liability Management ... it was decided to follow with some flexibility, the 22 critical policy and procedure decisions outlined by Sendero."

Each of "the 22 critical policy and procedure decisions outlined by Sendero" was then separately dealt with by the committee, and recorded in the minutes. These minutes evidence a maturing Bank-wide awareness of the importance and subtleties of asset and liability management.

Mr Paddison said that up until that time:

"I do not really think that you could say that we had a view within the Bank, about what a really full ALM capability, a proper embedded interest rate risk management practice was, and how complex it was, and how dependent it was on quality information out of your business." ()

He pointed out that "the first deficiency was the fact that we did not know what our embedded interest rate risk was globally ... I could be positive and Beneficial could be negative. We might have equal and offsetting positions. I would not know." ()

Mr Paddison testified that, consequent upon his attendance at the Sendero seminar, he became aware that "interest rate management can be a source of great profitability", and that asset and liability management is not just about managing the risk in the negative sense of containing risk. He said:

"... if you have got a very volatile period where interest rates are either falling sharply or rising sharply, if you've got major mismatches between your asset and liability profile you can lose a lot of money ... but similarly that very same circumstance is a great opportunity if you have got professional management for making money and in fact a sophisticated Treasury operation should be looking at the natural position and it should be saying to itself; we are too risk adverse. If we have a particular view and we have a particular natural capacity to absorb interest rate risk, then maybe we should be running larger positions and taking the profit potential. That is an important source of profitability ..." ()

He also said:

"... you could totally immunise your balance sheet from interest rate risk. You could absolutely match it, theoretically, if the hedging instruments were available, and so that there is no interest rate risk at all in your balance sheet at all but in a sense that would be foregoing what in a bank is a major, important source of profit opportunity." ()

He said that a bank can make money by exploiting the natural positions that its client base gives it. He said:

"If I was running retail banking now with what I know about asset and liability management, I think that I could make some very significant additions to profit through a much more deliberative management of interest risk in retail banking." ()

There is no evidence to suggest that, prior to this time, any person in the Bank had developed the degree of understanding of asset and liability management that was starting to develop. If that observation is not correct, then there is no evidence that anybody within the Bank attempted to give effect to the principles which were referred to by Mr Paddison.

From the minutes of a meeting of the second ALMAC, held on Thursday 15 June 1989 it appears that a representative of the Sendero Corporation was invited to address the members of the Board, the Executive Committee, and ALMAC, on 20 July 1989. The only Directors who attended were Mr D W Simmons and Mr W F Nankivell.() The next meeting of ALMAC after the visit was on 7 August 1989, but the minutes do not contain any reference to the meeting.

Mr Paddison's perception was that the Directors were struggling with the concepts of asset and liability management.

So far as the criticism that the reported profits of Retail Banking did not take into account the overheads of the Bank is concerned, Mr Paddison readily accepted that that was the position. He said "really it would be incorrect to use the term profit. You really should be talking about the contribution margin after direct operating expenses." () He has submitted that the comment applies to all operating divisions, not just Retail Banking.() He has also submitted that it is inappropriate to criticise either the Retail Banking division or himself for following what was approved Bank policy.

So far as transfer pricing is concerned, Mr Paddison claimed that transfer pricing "is always a vexatious subject". He said:

"I'm not against transfer pricing per se but transfer pricing systems can hide a multitude of sins and you can do an awful lot of very complicated work in putting a transfer pricing system that does absolutely nothing for your business. My view of transfer pricing is that transfer pricing is an important method for sending messages to people. One of the most important messages it sends them is about what is the true cost of funds and the second thing it tells them is what sort of preference they should have for certain sorts of term structures."

Mr Paddison has a more sophisticated attitude to transfer pricing than some of the other witnesses. He expressed his reservations about transfer pricing in the following way:

"... my view of some of the transfer pricing concepts that were put up was that they were poorly formed and that they were not necessarily going to achieve goals. They were not going to send accurate messages to people about what the Bank's proper cost of funds were. ... if you're going to transfer price first of all you've got to know accurately what your funds costs is. You have then got to reflect into that the cost of funds that is implicit in the way in which you borrow, whether you can borrow in particular maturity band very cost effectively. Then you've got all the arguments about, well, treasury sources, those costs of funds and then they transfer price them out, but they transfer price them at what benchmark? If they transfer price them at bank bill flat ... what happens if they are able to borrow under that? Similarly what is treasury's real cost? Who gets the benefit of the rating, and given that the rating is derived from sovereign status.

I mean, should in fact any part of the Bank be deriving benefit of that? Is that not a benefit that derive from, in fact, being owned by the shareholder. My opposition - and I can't recall opposing in a formal sense but I certainly recall opposing some real half-baked arrangements that had not properly thought through and dealt with a lot of these issues and had not properly said: why are we doing transfer pricing? Are we doing it for the purpose of sending proper pricing signals?" ()

Mr Paddison also raised an issue as to whether the treasury should be a profit centre or a cost centre. Treasury can be a cost centre in the sense that it raises funds at the lowest possible cost, and passes the funds to the lending units at that cost of funds. Treasury can be a profit centre in the sense that it passes funds out at benchmark, such as a market rate level for example the bank bill rate, so that any advantage which Treasury can derive from borrowing more cheaply is attributed as a profit to Treasury.

While an analysis of the merits of the different approaches is beyond the scope of this Investigation, the evidence establishes that the Bank should have had some means of measuring the cost of funds and divisional profitability. Mr Paddison said that "any bank must have a stable mechanism for sending signals to asset generators, people that are lending money, regarding its broad cost of funds." ()

Mr Paddison criticises those who have given evidence about his opposition to the introduction of transfer pricing in the Bank, on the basis that their comments reflect their own lack of understanding of the process, and their own lack of understanding of his objections.()

On the topic of marking the portfolio to market, Mr Paddison said that he was never opposed to the practice, but that it is a very deep subject and the process can be potentially very dangerous. He expressed a number of reservations about the practice.() He said that a debate within the accounting profession as to the relative merits of historical cost against marking to market still continues. He gave examples to demonstrate that the process of marking to market can give rise to aberrations in the published accounts.

On the topic of taking front end fees, Mr Paddison said "this is an area where once again I think the uninformed had a fair bit to say." He distinguished between two sorts of fees. One, being the genuine front end fee which is a recognition of the costs of the structure of the transaction, and the other being a fee that goes on over the life of the loan like a line fee or a commitment fee, which is taken into account immediately for profit.()

So far as cash flow forecasting is concerned Mr Paddison could not recall anybody being opposed to its introduction, but says that its absence "was always recognised as a major deficiency." He said:

"It was a responsibility that Kevin Copley struggled with at times, and there have been at times some quite heated discussions about why cashflow forecasting was not up to scratch."

Mr Paddison denies an assertion of Mr Copley that he resisted the introduction of cashflow forecasting at the time when Mr Copley first joined the Bank.()

Mr Paddison said "everyone acknowledged that it would be excellent if we had a cash flow forecast" (), but that nobody was able to grapple with the immense magnitude of the task. He agreed that the task required more resources than Mr Copley and the Finance department had available to them.() He said it required work in places other than in Finance, and described the introduction of cash flow forecasting as "a massive undertaking".

Mr Paddison said that if cash flow forecasting had been introduced sooner it would have indicated the proportion of revenue that was non cash. He said that if very good people had been monitoring the cash flow they may have pointed out that in Beneficial Finance, there was an acceleration of non cash income because Beneficial Finance was generating a lot of tax structure transactions. Such people may have also picked up trends where loan balances had been restructured and re-amortised.() He said, however that by the time discernible trends would have been noticeable there were at least three or four other indicators which were at least as important, and a lot less subtle than a cash flow forecast.

Mr Paddison believes that Mr Targett commissioned the Peats Report following discussions between Mr Targett and himself. He says it was the responsibility of Mr Targett to see that the recommendations were carried out. At the time of the interview, Mr Paddison was not able to recall the specific details of the report, but, on reading part of the report, Mr Paddison said that he did not necessarily agree with what was said.

Mr Paddison regarded Group Risk Management as a failure. He now has the view that one cannot achieve quality in a bank's practices by trying to "inspect it in". He pointed out:

"My view is that their job is not to go around inspecting risk and doing an audit job, that is compliance, and there is a very important role for audits and compliance. What group risk management should be doing is making sure that business unit leaders understand the risk that they have in their business, understand the way in which they originate risk and have the proper systems for monitoring as they are requiring it. The effort should go into making sure that the capability exists to understand and monitor at the time of origination, not inspect it.

While I think that group risk management, ALMAC, audit have all got an important role to play, one of the failings of almost all of the prudential practices we had at the time was that they were not tightly linked back to the accountability of the individual business unit head and that they were not there to - I saw group risk management's, for example, main role to be an internal consultant that would go around and they would say to each business unit: what are the risks you think you are managing? What are the information systems you've got to help them ...". ()

When asked what deficiencies he perceived in Treasury at the time Mr Targett arrived Mr Paddison identified trading for the sake of trading in fringe areas. He said that such trading had given rise to losses.()

Mr Paddison said that Treasury had a very indifferent profit history for most of the period until Mr Targett took it over. He attributed some of the losses to poor system support. He also gave evidence of a need for organisational restructuring, in the sense that it was necessary to be tighter about job objectives and focus. He said Mr Targett established an independent Treasury compliance unit and that he introduced much tighter daily and weekly profit reporting. Mr Paddison said Mr Targett got rid of a lot of people who had indifferent skills and established a training capability.() He said Mr Targett made a lot of innovations in a whole range of areas. It was the view of Mr Paddison that the improvements achieved by Mr Targett should have been made sooner.() He said that that had not been done partly because of the fact that there were inappropriate staff in Treasury, and partly "as a result of the way Treasury was established by Jim Hazel".() He said that Mr Hazel had excelled as a trader, but that he was "a dealer's dealer, not a general manager." () Mr Paddison said Ms Meeking "had been a very successful operator but ... she tried to logic the problems out rather than manage them out." ()

His summary of the role of the senior staff in the development of the Bank's Treasury was:

"So the history of our Treasury [was that it] had been run by a dealer who was in a management role [Mr Hazel], run by a dealer with a fairly strong academic background who tried to think through the problems but did not really have the management strength [Ms Meeking] and then a guy that although he had been a trader, was very ambitious, was very performance orientated and did have good management skills [Mr Targett]. Steve Targett was an extremely good, natural manager." ()

Mr Paddison said that Mr Hazel had just traded, and that Mr Hazel had not put proper systems and procedures in place. He added that "not all of what Jim did was bad by any means" and that Mr Hazel did some good work in establishing the Bank's capital market programme.

Mr Paddison said that what Mr Hazel "really needed was a good 2IC who had strong administrative skills ... But without that administrative support and without that strong management style, the infrastructure never got built, and Julie (Meeking) tried and did not really succeed, and it was not until Steve Targett came along that the infrastructure really started ... " ()

There is no reason to believe that this assessment of those who had been responsible for the development of the Bank's Treasury operations is anything other than a completely objective assessment by one who was in an excellent position to make such an assessment. Mr Paddison's assessment accords with the conclusion towards which other evidence tends.

When asked whether a commitment register and cash flow forecasting might have helped to avoid the present problems of the Bank, Mr Paddison said that cash flow forecasting would not have helped but that a commitment register would have made a difference in helping to produce information that would have showed the concentration of risk in property and the position of Beneficial Finance.()

Mr Paddison spoke in evidence, of the development of a liquidity policy. He said there had been a liquidity policy at the start of 1990 but it "was very broad and was not structured around negative scenarios." () He agreed that the Bank should have had an appropriate liquidity policy in place prior to 1990 but added that a proper liquidity policy had not been developed "because there was the feeling that in a crunch the liquidity of the Australian market would be maintained for a triple A borrower." () He agreed that the lack of emphasis on a liquidity policy prior to 1990 had been an error, because "I do not believe you should take anything for granted." ()

7.4.6 MR S C TARGETT (DECEMBER 1988 - 1991)

Mr Targett has provided a comprehensive signed statement to both this Investigation and to the State Bank Royal Commission. He has also given oral evidence to both this Investigation and the Royal Commission.

Mr Targett commenced employment with the State Bank as Treasurer of the branch in London. In December 1988 and January 1989, he relieved Ms Meeking while she was on leave. When the Bank was divided into Australian Banking and International Banking divisions, Mr Targett transferred from London to Australia, and assumed responsibility for the Treasury in the Australian Banking division. He reported to Mr Paddison. At the time Mr Targett assumed his position in Australia, he was responsible for approximately sixty five staff.

Mr Targett has stated that he is the person who commissioned the review and report from KPMG Peat Marwick Hungerford. He says that, during the two month period spent in the Australian Treasury, between December 1988 and January 1989 relieving Ms Meeking he had changed a few things. He must have made a good impression, because, after his return to London he received a telephone call from Mr Clark, offering him the job of Chief Manager, Australian Treasury in the restructured Bank. Mr Targett gave evidence that the Australian Treasury was functioning below market standards and that Mr Clark indicated to him there was a need to improve treasury operations. Mr Targett said that he knew from his previous visit that there were problems.

Mr Targett said the principal activities of the Adelaide Treasury were global funding and liquidity management, with limited forward foreign exchange, and strategic activities. The Adelaide Treasury operation incorporated the wholesale funding, liquidity management, and some of the asset and liability management, functions of the Bank. The prudential control was carried out in Adelaide. The Adelaide Treasury did not, however, have responsibility to oversee the general asset and liability management of the Bank. The relationship between the Treasury and ALMAC was not clear.()

He said that he was concerned because a lot of the people in the Australian Treasury did not have professional treasury experience, and the risk management practices and policies were sub-standard. It was his opinion that the Treasury was not performing in the sense that in one month it would make money and in another month it would lose money. He said that overall it just was not returning an acceptable amount to the Bank. He and Mr Paddison agreed that changes had to be made.

Mr Targett explained the inadequacies that he perceived with Treasury during the two months when he relieved Ms Meeking in December 1988 and January 1989 in the following way:

"In a broader sense I felt that the treasury department being centred here in Adelaide was relatively low on the sort of expertise that was required to run a professional treasury operation in the sort of deregulated market place that we have had in Australia for the last few years. Subsequently, you know, the results that were coming from the business were, in my opinion, less than satisfactory. There was no sense of real focus in the business. There did not seem to be a business plan in terms of where the people in charge were looking to take the business but just very much a focus on short-term profitability, whether it came from real profits or through accounting adjustment, and so on." ()

Mr Targett said there was a major problem with the Bank's statutory portfolio, that is, the Government stock held for statutory and liquidity reasons. He said that, at the time he relieved Ms Meeking, there was an environment of rising interest rates, but very little was being done to protect the value of that portfolio. He said it was a matter "that it was going to expose the Bank to a substantial loss if we did not do anything about it, so I spent a reasonable amount of my time during that two months in getting involved and helping to manage that portfolio." ()

This evidence is disputed by Ms Meeking, who says that it is not fair to say that very little was being done to protect the value of the statutory reserve asset portfolio. Ms Meeking has submitted that substantial hedging positions had been taken by the trader managing the portfolio in conjunction with herself, and that the need for constant readjustment was caused by the rapidly rising interest rates.()

I do not propose to resolve this conflict between Mr Targett and Ms Meeking but simply note the differing opinions.

Other deficiencies that Mr Target identified were that there were not the right sort of controls and policies in place for treasury operations. He also said "the rest of the business did not seem all that well structured". He referred to deficiencies in the SWAP activity and "a foreign exchange activity which really was not structured to be profitable and it was giving us quite volatile earnings".() He summarised the situation saying:

"The Bank was funded in a fairly haphazard manner in that time so in all I guess I was little concerned that as a treasury operation we really had a fair way to go in terms of getting it not only profitable, but doing the sort of things in the marketplace that I think the Bank would have demanded." ()

In addition, Mr Targett said:

"At that stage it had become a fairly sizeable player in the market and I think that there were two faults. One was obviously the people in charge did not really understand what needed to be done but secondly I think that the executive did not ... have an understanding of what it took to structure the treasury correctly, both from the point of view from risk controls and policy, but also to generate profit in a marketplace." ()

He gave evidence of wide significance that Treasury staff were using accounting quirks "trying to shore up the short term profitability of the area" because "they wanted to show the executive management of the Bank and the managing director that they were making the area profitable, although in a real sense if you looked at every risk that was on the book and marked all that risk to market, clearly to my way of thinking that was not the case." () He said:

"... there was not any measure in terms of how much risk they could put on the bank's books further down the track. They could keep doing that sort of thing to try and establish a short term gain. ... I think there was a negative yield curve and short-term rates were higher than the longer term rates and so therefore one of the things that they could do was essentially borrow longer term and deposit the money short-term. So, for example, if five year rates were 15% and short-term rates were 18% you could borrow on the five years, lend in the short date and all you would pick up is the difference between 15 and the 18 day to day, which would show a short-term profit, but obviously if you looked at the position overall that was not the case." ()

Mr Targett said that the job which he assumed encompassed everything relating to the on-shore markets, that "it was quite a sizeable job and arguably bigger than the job that Ms Julie Meeking was responsible for." ()

Mr Targett believes that the comments in Peats Report are accurate. He said he started working through the report from the time he returned to take up his permanent position in October 1989. Section 7 of the Peats Report contains an action plan. On 15 March 1990, Mr Targett and Mr S Luk provided to Mrs M Chin a status report setting out the steps which had been taken in pursuance of the action plan. Generally, all those matters which were within the province of the Treasury had either been implemented or were in hand by that time. Some recommendations, however, such as the first recommendation, namely, that the responsibilities of ALMAC and Global Risk Management be defined, had not been dealt with. Mr Targett did not deal with all the recommendations in the Peats Report because there were some which fell outside the responsibility of the Australian Treasury. What steps, if any, were taken to clarify responsibilities of ALMAC and Global Risk Management in the way suggested in the Peats Report, and to co-ordinate the programme of monitoring compliance with policies in Global Risk Management, remains unclear. There is no evidence before the Investigation that any steps were taken.

Mr Targett saw his role in Treasury "to try and develop an acceptable risk profile for the Bank and to try and create an earning stream which was less volatile than the one that was in existence ..." ().

In July 1990, Mr Targett was promoted to the position of General Manager Australian Treasury, but his duties remained the same. He continued to report to Mr Paddison. As a consequence of another restructure within the Bank, Mr Targett was promoted to the position, Group Treasurer, which later became General Manager, Global Treasury. At that time, it was felt that the separate existence of an Australian Treasury and an International Treasury was inappropriate. It was the opinion of both Mr Targett and Mr Paddison that the Treasury should be run as a single business to create scales of efficiency and have a manageable balance sheet.

As Group Treasurer, Mr Targett became responsible for the entire Treasury group. His portfolio was expanded to include responsibility for the supervision of the Bank's treasury operations in London, New York, Auckland, and Hong Kong, and for the Adelaide Capital Markets department. He established a Planning and Administration department within the Treasury and considered that his role was to develop proper policies, control and reporting standards that were consistent across the whole business.() The only treasury operation for which he was not responsible was Beneficial Finance. He did assume responsibility for Beneficial Finance on 1 July 1991.

Mr Targett was a member of the Executive Committee from November 1990, a member of ALMAC from November 1989, and a member of the ALMAC Technical Support Committee from November 1990.

Mr Targett said that he had a very good relationship with Mr Paddison, who was very supportive. He said that because of Mr Paddison, an appropriate framework was developed in the Treasury for limits and reporting guidelines in connection with the various risks.()

For the first five or six years of its existence, liquidity had never been a problem for the State Bank. Mr Targett said that towards the end of 1990, however, there was a concern about the ability to continue to fund the Bank in the domestic market at a pricing level that was consistent with national operating banks. He attributed that to problems associated with the State Bank of Victoria and Tricontinental. Because of those problems certain investors were not keen to hold State Bank paper. Mr Targett said that the unpopularity of the Bank's paper forced the Bank to buy back its own paper to support the price in the market rather than have its pricing move away from other banks.() The amount involved was $1.6B or $2.0B.() The Reserve Bank of Australia was kept fully informed. Mr Targett said the strategy was successful. During February 1991, when there was a concern that a liquidity crisis may develop for the Bank there was daily contact with the Reserve Bank.()

Because of his concern about the lack of experienced people in the Bank's Treasury in Adelaide, Mr Targett established the specialist group in Sydney. That strategy was not without risk, because it meant that there was an isolated highly autonomous group dealing in the Bank's name. The Sydney Treasury had responsibility for managing the Bank's Australian dollar interest rate risks with a maturity of greater than twelve months. It also had responsibility for the more detailed operations of the Treasury including an asset and liability management function for customer loans with a maturity greater than twelve months. The Sydney Treasury has continued to date, and the evidence before the Investigation is that it has been a success.

After a re-evaluation Mr Targett caused further work to be done in connection with the development of the Heaven software project which had been initiated by Ms Meeking. That work was mainly undertaken by the group in Sydney. By about the end of 1990 the Heaven system had been developed to the stage of which it gave the Bank the facility to market, with relative confidence as to accuracy, assets and liabilities with a greater maturity than 12 months.

By the time Mr Targett became Group Treasurer, the Group had a number of independent treasury operations. The New York Treasury had been established to fund the New York asset base. The Hong Kong Treasury was concerned with the distribution of Euro-commercial paper and deposit raising in Asia. The London Treasury had responsibility for funding the Bank's assets in that city and also traded. The Treasury in Auckland was responsible for the funding of the New Zealand corporate portfolio, certain strategic trading, and asset and liability management for the United Bank. In addition, Beneficial Finance had its own Treasury.

Mr Targett said that each Treasury was totally autonomous, and that common procedures were not implemented because of differing management approaches.()

On all the evidence it is clear that the proliferation of Treasuries, and the different reporting lines, prevented the proper co-ordination of treasury operations in the Group, and the ability to control such treasury operations was seriously impaired.

After Mr Targett left London, the trading in that Treasury became more speculative and losses which are referred to later in this Chapter were incurred. The trading activities of the London Treasury were subsequently abandoned, and that Treasury reverted to the role of funding the Bank's assets in London.

The Beneficial Treasury remained a separate operation until 1 July 1991. The evidence of Mr Targett is that the independent treasury operation in Beneficial Finance not only gave rise to inefficiencies, but was an actual hindrance, in so far as Beneficial Finance was in wholesale markets at the same time as the Bank Treasury. He said the Beneficial Treasury was accessing the same markets at different rates and took credit availability away from the State Bank Group.() Mr Targett said the Beneficial Treasury actively fought to preserve its own independence, but was not slow to seek assistance when it was needed. He said "They only put their hand up when they needed you, like they couldn't fund some asset growth. They were just feeding off the Bank's name." ()

In his statement(), Mr Targett sets out, what in his opinion, were the biggest problems in the Australian Treasury in 1989. He says they were:

(a) the risk management book was not being well managed;

(b) the Foreign Exchange department was unprofitable; and

(c) the standard of treasury staff was generally poor, due to the location of the Treasury in Adelaide.

It was because of the last matter that the risk management activity was moved to Sydney.

Two other problems referred to in Mr Targett's statement are the funding of non accruals and liquidity management.

Ms Meeking has confirmed that the foreign exchange activities were unprofitable and that there were problems with the expertise of the staff. Ms Meeking told the Investigation that towards the end of 1988, she recommended the employment of a talented senior dealer with whom she had previously worked, but her suggestion was thwarted when the Bank acceded to a request from that persons current employer to withdraw the offer of employment. She also told the Investigation that, by mid 1989, she recognised that major change was needed in the area and that she put a restructuring proposal to Mr Mallett. Mr Mallett, however, agreed to a request from Mr Targett that no changes be made pending Mr Targett's arrival in Adelaide. Ms Meeking said that the area "continued its lack-lustre performance for the next 6 months". Ms Meeking also told the Investigation of staffing difficulties caused by a Bank policy which made it difficult to move employees who had progressed through the Bank and its predecessors, rather than come in as professional dealers.()

Liquidity management is a matter considered in the Peats Report. At paragraphs 219-228 it is said:

"There are apparently no formal policies addressing control over State Bank's liquidity risk. Whilst it is acknowledged that the unique status of a bank reduces the exposure in this regard, this does not eliminate the need for such risks to be monitored and regulated, particularly for State Bank's off-shore activities."

In his statement, Mr Targett said he agreed with that statement in the Peats Report at the time. He said that while some of the off-shore operations of the Bank, such as the London Treasury, did have their own liquidity policies, the Bank did not have a firm liquidity policy in Australia. Mr Targett said "domestic liquidity management was an area in the Bank which was neglected to some extent".() He said that Mr Hazel and Mr Mallett had been responsible for the preparation of domestic liquidity guidelines; but that if such guidelines were in place he was unaware of them. The inference is that they did not exist. He said that when he took up the position of Chief Manager, Australian Treasury, he asked a group of people to have a look at the Bank's liquidity situation.() Mr Targett believed that the liquidity risk was the major risk that any bank faced.()

From the documents annexed to Mr Targett's statement it is clear that liquidity management is a subject that attracted increasing attention within the Bank during 1990. The need for a formal policy was recognised, and over a period of time a Global Liquidity Policy was developed. It was proposed that the responsibility for global liquidity management be delegated by the Board to ALMAC. In addition, it was proposed that the Global Treasury would assume centralised control of liquidity management, under delegated authority from ALMAC, and that the Global Treasury would take a pro-active role in the planning of group asset creation. It was proposed that the Group Treasurer would be granted control over group assets and liabilities in a crisis. Drafts prepared during the formulation of the policy acknowledged that "the current information systems do not provide sufficiently reliable data or in many cases data in the appropriate format for liquidity reporting".()

Liquidity management is a matter dealt with separately in more detail later in this Chapter.

An underlying theme in Mr Targett's evidence is that, prior to his arrival at the State Bank, there was nobody with the background or experience to fully comprehend the problems that were inherent in a bank treasury of the size that the Treasury in the State Bank had become. In his evidence to this Investigation he said "in terms of the general sense, there wasn't any treasury specialist in the Bank until I came along." ()

From its comparatively modest beginning at the time of the merger the Treasury in the State Bank had, by the end of the period under review, developed into a sophisticated international operation.

Mr Targett gave evidence that, at the time he left the Bank in October 1991, he went to the Board with a summary of things which he believed still needed to be done. The first item on his list was prudential management.()

 

7.5 ISSUES WHICH ARE RAISED BY THE EVIDENCE

 

This part of the Report considers a number of discrete aspects of the Bank's asset and liability management and Treasury operations which have assumed significance in the evidence heard by the Investigation.

7.5.1 THE FIRST ALMAC

The first ALMAC was abolished by the Executive Committee on 31 July 1987. The reasons stated were a perceived need for "... quickness of decisions and the ability to react quickly to the economic climate".() It was proposed that decisions previously made by the first ALMAC would be made by the divisional general managers, and confirmed by the Chief General Manager or, in his absence, the Managing Director. Mr Copley, who had recently been appointed the Chief Manager, Finance and Planning, was to oversee the process for the purpose of gauging the effect on the balance sheet.

Because a complete set of the minutes of the first ALMAC are not available for inspection it has not been possible to determine accurately what that committee did. The role actually played by the committee is unclear. The members of the first ALMAC who have been interviewed in connection with this Investigation, no longer have any useful recollection of the proceedings of the committee. Furthermore, it has not been possible to determine the precise relationship between the first ALMAC and the Treasury.

Minutes of the first ALMAC were noted in the Board Minutes. A perusal of those notes reveals a progressive move away from the broad objectives, described in Mr Clark's memorandum to the Board of 28 June 1984, towards management of the pricing risk. Other evidence confirms that, by the time of its dissolution, the first ALMAC had become effectively nothing more than a pricing committee. Mr Hazel said that it "considered the cost of funds, what the market was doing and set the rates".

The Investigation has been provided with minutes of 27 of the 79 meetings of the first ALMAC held up to 14 January 1987. At most of the meetings for which minutes are available the Chairman was Mr Matthews. The meetings were rarely attended by Mr Clark. The minutes show that the topic of interest rates dominated discussions at the meetings. During 1985, the topic of liquidity was raised at some meetings of ALMAC, but the first ALMAC apparently did no more than to note the contents of the Quarterly Operating Review on the subject.

The minutes show that at meeting number 28(), on 29 October 1985, the first ALMAC considered an information paper from Mr C W Guille dealing with:-

". Pricing the flow of funds between profit centres (the Earnings Credit Rate).

. Transfer pricing; and

. Base Indicator Rate."

Prior to his employment with the State Bank, Mr Guille had been seconded to the State Bank, for a period, from the Reserve Bank.

The minutes record that:

"The Earnings Credit Rate [ECR] has been developed for the pricing of internal funds flows between the Bank's profit centres. The ECR is based on the average monthly interest rate for Term Deposits over $50,000, which was regarded as a representative rate for wholesale deposits".

The minutes record that transfer pricing was partially in place for branches. It was described as:

"... the sharing of loan fee income for general, concessional housing and rural loan applications, transactions [notional cost]."

I mention in passing that this type of transfer pricing is not necessarily the same thing as the transfer pricing which is referred to elsewhere in the Report.

On the topic of the Base Indicator Rate, the minutes record:

"The paper presented a brief overview of the method of calculating a base indicator rate on which all pricing structures could be based. The formula is made up of the following elements:

. cost of funds;

. management expenses;

. profit margin.

The formula provides for a risk factor through the building in of provisions for bad and doubtful debts within the management expense cost. The indicator rate would be used to determine product positive or negative earnings.

ALMAC acknowledged it was important the Bank should not carry too many negative earning products ...

[Mr Guille's] proposal that the base indicator rate be provided each meeting to be used as a yardstick for pricing products in any future decisions was endorsed."

The minutes contain a suggestion that the Bank was attempting to put in place proper asset and liability management practices. The proposal for a base indicator rate was in fact a proposal for a form of transfer pricing. What was described in the minutes may in some ways be elementary compared with what is expected today. If, however, Mr Guille's initiatives had been followed through,they would have provided a foundation upon which proper asset and liability management could have been based. Unfortunately, the procedures that were discussed on 29 October 1985 were not followed through, and the suggestions were apparently over-looked with the passage of time.

Meeting number 28 is of significance for other reasons. Another report,presented by Mr Guille, made recommendations as to Information Requirements for ALMAC Meetings. Included was a recommendation that ALMAC "monitor risks [and] opportunities in the balance sheet structure of assets and liabilities." The meeting agreed that the Planning department would develop a suitable suite of reports; but, like the other recommendations made by Mr Guille, there is no evidence that the recommendations were carried into effect.

At meeting number 32, on 12 December 1985, a paper was presented by Mr Guille dealing with "Prudential Arrangements". There was an acknowledgment of the fact that there was no single group responsible for monitoring the Bank's prudential controls, and that there was a consequent need to co-ordinate that management function. The paper "proposed that ALMAC maintain a general watching brief on the Bank's various internal prudential guidelines and industry/credit levels". The Committee reached agreement on a number of proposals designed to achieve that end.

The paper contained a recommendation that ALMAC:

"...

. maintain a general oversight of the Bank's risk position in relation to prudential guidelines;

. foster the development of new systems, as required, to monitor business risk - particularly on a bank wide and (potentially) group basis."

The memorandum referred to an extensive range of internal prudential guidelines relating to capital adequacy, liquidity, direct credit exposures (domestic and overseas), contingency exposure, foreign exchange, and money market dealing limits etc. In addition, the memorandum included the comment:

"While recognising the specific responsibilities of departments and divisions for monitoring business risk, there needs to be one committee in the Bank that maintains a general watching brief on the Bank's risk position and encourages the development of new systems to monitor risk - particularly in bank wide and (group) situations." ()

Notwithstanding this reminder of the importance of asset and liability management, the first ALMAC took the course that it did.

Meeting number 32 was the last ALMAC meeting attended by Mr Guille prior to his return to the Reserve Bank. The minutes record the committee's appreciation of his "... outstanding contribution to the development and operation of ALMAC's responsibilities ...".

In so far as the papers presented by Mr Guille provide the only evidence which the Investigation has seen of any attempt by the first ALMAC to involve itself in the type of asset and liability management that was necessary, the expression of gratitude by the Committee for the work of Mr Guille was well justified.

At meeting number 50, on 8 May 1986, the committee discussed a paper by Mr Hazel dealing with the desired maturity pattern of the Bank's liquid assets.

Meeting number 53 was called on 20 May 1986 in response to an Executive request that ALMAC reconsider its role to ensure that it was operating as effectively as possible. The minutes of that meeting record:

"The Managing Director is keen that ALMAC take a much stronger position in the organisation and that it act more in a manner to control the Bank's balance sheet."

At that meeting, the role of ALMAC was considered and the following definition of ALMAC's function was adopted:

"ALMAC is a proactive group responsible for managing the financial outcome of the Bank's interest margin through the manipulation of the Bank's assets/liabilities to achieve an interest/fee margin consistent with budget objectives"

The functions of ALMAC were described as:

". The setting of interest rates.

. Assessing the impact of its decisions on profit performance.

. Maintaining the Bank's price competitiveness.

. Advising Management and the Board of Directors on conflicts between the above three items and the Bank's agreed objectives.

. To manage the interest/fee margin in response to budget objectives."

The focus on pricing which has been referred to by many witnesses, is confirmed by these minutes. In addition, the functions of ALMAC that are described fall a long way short of what is required to properly manage the assets and liabilities of a bank. The inference is that by this time the need for full asset and liability management had either been overlooked or was not regarded as important.

The minutes of meeting number 53 also record:

"ALMAC agreed that the integrity of the information provided in the Monthly Operating Review was in need of fine tuning due to peculiarities associated with the recording of figures within the General Ledger. In addition, ALMAC should also review a number of accounting procedures to limit the incidence of non-accrual of fee income which may not be appropriate."

Because these minutes were only made available to the Investigation following the release of the draft report for natural justice purposes, it has not been possible to fully investigate the implications of this minute. It does, however, corroborate other evidence about anomalies in the Bank's accounting procedures.

Apart from the minutes already referred to, this Investigation has not seen any evidence that the first ALMAC was actually engaged in the task of asset and liability management.

Mr Hazel gave evidence to the Investigation:

"It was a pricing committee, essentially ... It was not concerned with asset and liability management really in the sense you would describe it today in terms of balance sheet structure. It was ... more concerned with pricing. The decisions ... it took were more in relation to ... Indicator rates and housing rates more than structure of the balance sheet." ()

Mr Hazel's statement is consistent with all the other evidence before the Investigation.

The minutes of the Board meeting refer to an information paper by the Managing Director regarding the abolition of the first ALMAC and the need to reduce the time of senior management at committee meetings. The information paper can not now be located in the working papers.

Because the first ALMAC was in fact dissolved it may be inferred that the committee was not perceived to be carrying out any worthwhile function within the Bank, and that there was a perception that the committee had no worthwhile function to carry out.

On all the evidence before the Investigation, I find that, after the first ALMAC was dissolved, there was no person or committee within the Bank formally charged with responsibility for the overall management of the Bank's assets and liabilities.

Mr Clark gave evidence that it was Mr Matthews who originally had responsibility to take an overview of the Bank's asset and liability management. He said that the first ALMAC was dissolved at the time of the appointment of Mr Copley as head of finance and that:

"... there was a paper that went to the Board or the Executive Committee at about that time saying it was considered that pricing should be the responsibility of the line general managers, and with Copley coming on board he could - as head of finance overview the total financial situation in the group." ()

The Investigation has not seen any evidence that the Bank was either alert to the need for overall management of its assets and liabilities, or that it did in fact attempt to co-ordinate the management of its assets and liabilities during the lifetime of the first ALMAC. There is no evidence that the first ALMAC was actually involved in asset and liability management. It did not fulfil the elementary charter contained in the memorandum from Mr Clark to the Board, dated 28 June 1984.() The suggestions which were made in the papers presented by Mr Guille in October and December 1985 were not put into effect. The first ALMAC must be regarded as a failure.

Whether the reason stated in the Executive Committee Minutes for the dissolution of the first ALMAC was correct is unimportant. What is important is that at the time of the committee's dissolution neither the Board, the Executive Committee, nor members of senior management, showed any appreciation of the need for, or the importance of, asset and liability management. There is no evidence to suggest that there was anything other than a complete abdication of responsibility and abandonment of the task.

On all the evidence I have reached the following conclusions about the first ALMAC.

(a) The first ALMAC was effectively no more than a pricing committee. It never assumed the role contemplated by the memorandum of Mr Clark to the Board dated 28 June 1984. In particular, it was never concerned with the overall management of the Bank's assets and liabilities.

(b) At the time that the first ALMAC was dissolved, the overall responsibility for asset and liability management was either vested in Mr Copley, or it had been overlooked. In either event the function was not carried out.

(c) If the overall responsibility for asset and liability management had been vested in Mr Copley, which I doubt:

(i) Mr Copley was not aware of that fact.

(ii) Mr Copley had no training or experience to equip him to be responsible for the overall asset and liability management of a bank such as the State Bank.

(iii) There was no follow up by the Board of Directors, the Executive Committee, or the Managing Director, to ensure either that Mr Copley was in fact attending to the overall asset and liability management, or that the function was being attending to at all.

7.5.2 THE SECOND ALMAC

An appreciation of the need for asset and liability management was revived following the attendance of Mr Paddison and others at a seminar interstate conducted by the vendors of the Sendero software package. An Asset and Liability Management Steering Committee first met on 24 June 1988. The Chairman of the meeting was Mr Mallett. Mr Paddison, Ms Meeking, and Mr Copley, were also present together with seven other persons.

The Steering Committee met again on 11 July 1988. The summary of the meeting records that the committee reviewed the Asset and Liability Management (ALM) conference attended in Sydney and concluded that the conference was very informative and relevant.

The summary of the meeting also records that an ALM Committee was needed to manage the assets and liabilities as a whole".()

At a meeting of the Steering Committee, held on 26 August 1988, it was "agreed that Asset and Liability Management [ALM] should go live" and it was resolved "that a paper be formulated and presented to the Executive Committee recommending the establishment of a formal ALM Management Committee. The ALM Management Committee is to consist of the senior executives of the Bank." ()

As a consequence, on 19 September 1988, recommendations were made to the Board of Directors that an Asset and Liability Management Committee be formally constituted within the Bank, and that a support group be constituted within the Treasury division to provide technical support to the Asset and Liability Management Committee. The recommendations were, in due course, approved by the Board, and the first meeting of a new Asset and Liability Management Committee ("the second ALMAC") was held on 23 September 1988.

The initial members of the second ALMAC were Mr Mallett, General Manager, Treasury International (Chairman), Mr Masters, General Manager, Corporate Banking, Mr Paddison, General Manager, Personal and Business Banking, Mr Copley, Chief Manager, Group Finance, and Mr D J Gobbett, Economist. Other people, including Ms Meeking, attended the meetings of the second ALMAC by invitation.

The need for asset and liability management is evidenced by an undated paper presented to the Asset and Liability Management Steering Committee by Mr L Fusco and Mr P Takos. The paper begins with the statement:

"In today's environment of volatile financial markets, decreasing margins and increasingly complex financial transactions it is essential for the State Bank of South Australia to effectively manage its assets and liabilities. Asset and Liability Management (ALM) will enable the Bank to unlock its balance sheet and to manage the potential profitability available to the Bank."

The authors of the paper recommended that the Asset and Liability Management Committee should be ultimately responsible for the management of the Bank's assets and liabilities. They commented:

"As ALM is of such importance and has such wide ranging ramifications it is essential that the senior executives have the major role in the ALM decision making process and thus form the basis of ALMAC." ()

At about the time the second ALMAC was established, inquiries were made by Ms Meeking and Ms A Kimber as to the way that asset and liability management was carried out in other financial institutions. The notes of their enquiries confirm that other financial institutions had quite different approaches to the matter. Ms Kimber, who spoke to the State Bank of Victoria, noted that Bank did not appear to be quite as advanced as the State Bank of South Australia in terms of asset and liability management.

Minutes of the second ALMAC are available and have been inspected. While the establishment of the second ALMAC was undoubtedly a move in the right direction, the proceedings of the second ALMAC were initially concerned, almost exclusively, with interest risk analysis and scenario modelling. Much of the business was related to the evaluation and testing of two modelling systems ("BRMS" and "Sendero"). The eventual conclusion was that neither of those systems provided the necessary facility to mark assets to market because they relied upon data which was not readily available in the Bank. The debate as to which system is the better continues in the Bank until today.

It was not until the time when Mr Targett became a member of the second ALMAC, and Mr Paddison became responsible for both the lending and funding divisions of Australian Banking, that there was a proper focus on asset and liability management.

With respect to the second ALMAC, Mr Targett made the observation in his statement:

"From almost my first days at the Bank, I felt unsure what ALMAC's framework or focus was. From discussion I had with people in the market their committees handled things very differently. They looked at all asset and liability growth within the balance sheets. [SBSA's] ALMAC was not doing this. As such, we were expressing concern that the focus of ALMAC was not what it should be." ()

These concerns were also reflected in a memorandum, dated 22 November 1990, from Mr A K Smith, Manager, Money Market, to Mr Targett, on the subject of Group Liquidity. The memorandum contains a number of detailed and astute recommendations. The fact that the recommendations were made, by itself, evidences the growing understanding of deficiencies which existed at that time. The memorandum observes:

"The role of ALMAC should be balance sheet management. This role should incorporate control over the transfer pricing system and adjustment to that regime to solicit the desired product mix for liquidity and interest rate risk management objectives." ()

This evidence shows that, after the Bank had been in operation for more than six years, it was still grappling with the fundamentals of asset and liability management. The uncontradicted evidence is that the balance sheet of the Bank had been virtually without co-ordinated management from the formation of the Bank until late 1990.

Mr Clark had been an ex-officio member of the first ALMAC but he attended few meetings. When interviewed for the purposes of this Investigation, on 30 October 1991, he was unable to recall ever attending meetings of the first ALMAC, and was unable to say whether he was comfortable that the Committee was doing what he wanted it to do. He could not recall the reason for the dissolution of the first ALMAC, and he was unable to throw any light upon the establishment of the second ALMAC.() There is evidence that he did not understand asset and liability management.() His emphasis was on profit and growth, not treasury risks.()

There is a text book called "Managing Bank Assets and Liabilities". The title is self explanatory. The book consists of a number of Chapters on different aspects of asset and liability management written by experienced bankers and academics. It is highly regarded by the consultants who have given assistance to this Investigation. A chapter entitled "The ALM Function: Development and Strategy" sets out the following requirements for an asset and liability management committee:

"ALCO's [another name for an ALMAC] are characterised by a few key aspects:

- active Chief Executive Officer involvement;

- participation of all of the Bank's main business units responsible for changes in the Bank's balance sheet;

- participation by members of the Bank's finance function [CFO, Treasurer, Comptroller];

- dedicated support;

- regular meetings." ()

In the case of the State Bank these requirements were not fully satisfied. In particular, there was no active participation by the Chief Executive Officer.

Mr Clark has submitted that he was on a short term contract, and that asset and liability management was not his area of expertise. Mr Clark believed he had appointed people who were competent in the area, although he says he is prepared to accept proper criticism for the management of assets and liabilities.()

In my opinion, as Chief Executive Officer of the Bank, Mr Clark should have ensured that proper asset and liability management procedures were in place, and he should have actively involved himself in those procedures. He was the only person in a position to take a complete overview of the Group's activities.

The Peats Report recommended that the scope of ALMAC be expanded to include the full State Bank Group. The minutes and working papers of the second ALMAC show that this was done during the first half of 1990, and, in July 1990, a liquidity report was prepared for the State Bank Group for the first time. The evidence is that, prior to July 1990, the Bank's asset and liability management had been confined to the Bank alone.

In my opinion, the recommendation in the Peats Report was completely appropriate and the Bank should have considered asset and liability management on a group-wide basis from the time when the Bank commenced business.

The second ALMAC has continued to meet to the present day. Nobody has disputed the need for such a committee. As time has progressed both the range of activities of the second ALMAC, and its perceived importance within the Bank, has increased.

7.5.3 GLOBAL RISK MANAGEMENT

Another group within the Bank that had a peripheral concern with asset and liability management was Global Risk Management. The charter for Global Risk Management, which is set out in Chapter 5 - "The Management of the Bank Groups Diversifiable Credit Risk" of this Report required, not only that Global Risk Management give priority to credit risk, but that it also give attention to other risks including "capital adequacy" and "liquidity". The charter stated "specifically, GRM will: ... participate in and support asset and liability management processes within the Bank and Group."

The Peats Report recommended a revision of the charters of Global Risk Management and ALMAC to emphasise Global Risk Management's prescriptive policy role and monitoring responsibilities, and ALMAC's strategic focus.() In addition, the Peats Report pointed out that "there is a need to clarify the respective roles of Global Risk Management, Asset and Liability Management Committee (ALMAC) and the individual business units as there are varying perspective in the relationship between these two groups within State Bank." ()

I accept that the recommendation in the Peats Report, with respect to the clarification of the respective roles of Global Risk Management, the Asset and Liability Management Committee and the individual business units was appropriate. There is no clear evidence to suggest that the recommendation was put into effect. The evidence is that there was, at the time of the Peats Report, no person or body in a position to take an overview of asset and liability management for either the entire Group or the Bank itself. In an oblique way the Peats Report signalled this deficiency, but the message was not understood.

Mr Mallett gave an example of the inability of global risk management to properly fulfil its function.

He said that a matter that may not have been emphasised to the directors:

"... was the fact that Beneficial had a reported balance sheet of $2.0B, a real balance sheet of $3.0B plus and it was heavily property related. At the same time the bank was, by traditional banking, heavily property related. It was a double whammy." ()

So far as asset and liability management is concerned, I have heard no evidence to cause me to disagree with Mr Paddison's view() that Global Risk Management was a failure.

The role that Global Risk Management played in asset and liability management was only ever intended to be peripheral. Moreover, there is no evidence that it fulfilled the requirements of its charter with respect to asset and liability management, capital adequacy or liquidity.

7.5.4 ISSUES RELATED TO TRANSFER PRICING AND THE COST OF FUNDS

7.5.4.1 The nature of and need for transfer pricing

Transfer pricing is an accounting process by which the divisions within a bank are debited with the notional cost of the funds and facilities which they use. That cost may include the interest cost, an allowance for the cost of the Bank's unallocated infrastructure or overhead costs, and an allowance in respect of capital and provisioning effects. The process calls for a determination of the transfer price. For that reason, both the use of a transfer pricing system and the cost which is attached to funds by the application of a transfer pricing system can be very controversial. To the extent that operating divisions are required to pay for the funds which they use, there is a reduction of the operational profits. Accordingly, operating divisions are traditionally opposed to transfer pricing. The treasury of a bank is, by the process of transfer pricing the cost of funds, credited with a fee for providing a service, namely the provision of the funds to the operating division. That fee can reflect a notional profit in the treasury. Thus, transfer pricing is a procedure that assists with the assessment of the contribution to profit of the various divisions of the bank.

Evidence has been given to the Investigation that, if the Bank does not transfer price the cost of funds, or have an appropriate alternative, it cannot accurately determine whether a particular division is trading profitably or not.

In the beginning, the Bank did not have a system for transfer pricing the cost of funds. There was no transfer pricing at the time that Ms Meeking was engaged by the Bank in July 1987. The introduction of a system of transfer pricing was one of the objectives which she set herself. Her evidence is "that transfer pricing was essential if the Bank was to have any idea of the contribution of each of the divisions to the bottom line of the Bank".

Transfer pricing was first carried out in August 1988 for the month of July.() There is conflicting evidence as to whether it was introduced following Ms Meeking's initiatives, or whether it was a consequence of the divisionalised accounting system that was introduced by Mr Copley. It is likely that both played a part. Ms Meeking did push to have transfer pricing introduced. Mr Copley did introduce divisionalised accounting. Divisionalised accounting would not have been possible without some form of transfer pricing.() Mr Paddison has given evidence that while Ms Meeking was interested in transfer pricing for the funding side, because Treasury was a supplier of funds to other divisions, she had no involvement and no responsibility for, the expense side. He said that was a finance function and that transfer pricing was introduced by Mr Copley and the Finance department.()

A submission made to the Investigation by the Bank has pointed out the confusion that can arise if transfer pricing is treated in a general fashion with no clear separation of matters related to transfer pricing for cost of funds, transfer pricing for unallocated corporate overheads, and transfer pricing to correct for capital and provisioning effects.() The distinction is a proper one to draw. None of the early evidence given to the Investigation, however, made the distinction, and the evidence therefore needs to be treated with caution in order to avoid confusion. When asked to clarify her evidence, Ms Meeking said to the Investigation that there were two aspects of the transfer pricing to which she referred, namely, transfer pricing of the interest rate cost and benefit of funds, and transfer pricing for the allocation of overhead costs. She said that transfer pricing to correct for capital and provisioning was never an issue while she was employed at the Bank.()

When it was first introduced, transfer pricing was confined to transfer pricing of the interest rate cost and benefit of funds. It was not until around the middle of 1990 that transfer pricing was introduced to allocate overhead costs. A proposal to introduce transfer pricing for capital and provisioning effect was put forward in 1990 but not pursued because the executive committee found it too difficult to understand.() There is no evidence that transfer pricing to correct for capital and provisioning effects was introduced at any time during the period under review.

The three types of transfer pricing require quite separate processes. In the Bank, it was only possible to implement transfer pricing of interest rate costs and benefits with the use of Kapiti, which was the Treasury software. The allocation of overhead expenses had to be carried out through the Bank's general ledger, which was under the control of the Finance department. Likewise, transfer pricing to correct for capital and provisioning effects could only be achieved through the Bank's general ledger.()

Most of the evidence on the subject of transfer pricing appears to be directed at the first category of transfer pricing. For that type of transfer pricing to be put into effect, it was necessary for the Treasury, on the one hand, and the operating divisions, on the other hand, to agree on the transfer pricing margin. Agreement was reached that the margin should be 0.05 per cent. Funds used by the operating divisions were debited at a bench mark, such as the floating bank bill rate, plus the margin of 0.05 per cent which produced a notional profit in the Treasury.

For the second and third types of transfer pricing to be carried out it is also necessary that an agreement be reached by the divisions effected. For overhead costs to be transfer priced an agreement must be reached between the divisions which incur the overhead cost and the user divisions. This raises issues of what is a reasonable cost, and what proportion of the cost should be allocated to the user division. The user division may take the view that the costs are unreasonably high because of the inability of the division providing the services to contain its cost, or the user division may complain that it is being asked to bear too great a proportion of the costs. There is a view that if the user divisions are to be required to pay a proportion of the overhead costs, they should have some say in the incurring of these costs.() These issues can only be resolved by agreement and the negotiation of that agreement may give rise to acrimony. It obviously calls for decisions of an arbitrary nature.

Ms Meeking gave evidence that transfer pricing of overhead costs had not been introduced at the time she left the Bank.() For that reason, and because it is transfer pricing of the cost and benefit of funds that effects the Treasury the most, the Investigation has treated the evidence relating to transfer pricing as relating to that form of transfer pricing. Accordingly, where there is a reference to transfer pricing in this Report that is to be read as a reference to transfer pricing of the cost of funds only, unless the contrary appears.

Initially, transfer pricing showed that the Treasury was operating at a loss. There is a conflict between the evidence and in Mr Copley and the evidence of Ms Meeking. Mr Copley said:

"When I started to produce the figures on a divisionalised basis, using a transfer pricing mechanism within that system that she (Ms Meeking) was happy with, she had no choice but to accept the fact that it was Treasury." ()

Ms Meeking acknowledged that the initial results of transfer pricing showed that Treasury was making a loss, but she attributes that to the fact that the Finance department had not given Treasury a balanced balance sheet.() She says it took until November or December 1988 to finally get a balanced balance sheet in place. She says that it was not until the end of 1988 that she was confident that the Bank had transfer pricing under control.() It was Ms Meeking's view that a system of transfer pricing was working satisfactorily by the end of 1988.()

Mr Copley has acknowledged that it took several months before transfer pricing was carried out correctly. He says, however, that once transfer pricing was working correctly the Treasury was not achieving its budgeted profit figure, although it was operating at a profit.()

Mr Targett confirms Ms Meeking's view that transfer pricing is essential. He said:

"... clearly you have got to have a mechanism that sends the right signals to the borrowers and lenders in terms of what behaviour they should adopt. So the broad objective of transfer pricing should be to make the lenders aware of what the bank's cost of funds are, and also if people are borrowers and the bank is a net lender, well, you know, clearly they should be rewarded for behaviour in which they bring funds in the door. I think transfer pricing is something that is absolutely essential. It is a question of how it is organised and set up." () [Emphasis Added]

Mr Targett did not share Ms Meeking's view that transfer pricing was working satisfactorily in the

Bank by the end of 1988. He said:

"... where we came short of the mark because our transfer pricing policy tended to just focus on the cost of the bank raising short term funds, and what started to happen over time is that our longer term cost of funds became more expensive, but our transfer pricing policy did not reflect that. So, you know, one could argue: yes, we would set it up, but perhaps we need to do some more work to refine it to properly reflect what the lender should be costing into their transactions" () [Emphasis Added]

Mr Targett's opinion that the system of transfer pricing required refinement is confirmed by the Peats Report, which considered the position as at September 1989.

In connection with the question of whether the Board had been receiving adequate reports to show which departments were making a profit and which were making a loss, Ms Meeking said:

"I think the Board certainly did understand, after we put in place transfer pricing, who was profitable and who was not. I don't think they understood before it was put in place that there was no transfer pricing and therefore the reporting was defective." ()

It was also her view that the Board probably did not understand that transfer pricing had not previously been in place. She said "I think they always assumed there always was transfer pricing in place." () That was her impression of senior management as well.()

Ms Meeking said that, before transfer pricing was put in place, she was regularly asked why Treasury was not performing on budget. She said the reason for that question being raised was that the Finance department was reporting in a non-sensical way, and that, after transfer pricing was implemented, the figures showed that Treasury performed significantly over budget.()

Mr Copley agreed that at the time he arrived at the Bank the way in which the Bank reported its profits was meaningless. He said that there was no reporting of profits by division through the official accounting systems, and that "the people running the various operating divisions were producing their own figures on what they thought they were making." With the support of Mr Clark, he divisionalised the management accounting systems.() Transfer pricing was necessary to produce the divisionalised accounts.()

I accept Ms Meeking's evidence about the misleading nature of profit reporting prior to the introduction of transfer pricing. I am unable to accept that the absence of transfer pricing was the only deficiency. In my opinion, the need for transfer pricing and the need for divisionalised accounts went hand in hand.

The Investigation has not attempted to compare the performance of Treasury against its budget through the period under review. Mr Targett did not regard the Treasury as being profitable. This matter is discussed in more detail in a later section of this report, which considers Treasury as a profit centre. What is significant for present purposes is that there is room for debate as to whether Treasury was profitable or not. The fact that such a debate can exist supports the conclusion that, by December 1990, the Bank had still not put in place measures which were universally accepted as being reliable and accurate for the reporting of divisional profits.

There is conflict between Ms Meeking and Mr Copley as to who initiated the introduction of transfer pricing. Ms Meeking said that the development of the Heaven software, marking to market and transfer pricing "were all things that, ultimately, my area did on its own". () She says, however, that transfer pricing could not be introduced without the agreement of the Finance department "and they finally did agree to facilitate the transfer pricing, but the actual mechanism was carried out within Treasury and ... that was frustrating and caused quite a bit of grief between Treasury and Finance Department".() It was her opinion that transfer pricing should have been set up with the Bank's general ledger.

Mr Copley maintains that any suggestion that he or the Finance department had been resistant to the introduction of a transfer pricing system is not true.() He agrees that the introduction of transfer pricing needed the agreement of the Finance division, but says that he insisted, with the agreement of Mr Clark, that changes to the systems should not be piecemeal.() In my opinion, the fact that Mr Copley did introduce divisionalised accounts tends to negate the suggestion that he obstructed the introduction of transfer pricing.

Mr Mallett is not a supporter of the practice of transfer pricing. He said that he "always believed transfer pricing to be something debilitating in regard to most organisations".() As Ms Meeking's superior, however, he did support her.

Mr Paddison's evidence about transfer pricing has been discussed above.() He is aware of both advantages and disadvantages. He does not oppose the principle of transfer pricing(). His view is that transfer pricing has the potential to be inefficient and costly. He favours a simple system which can be easily implemented. He admits that he was opposed to some of the early suggestions that transfer pricing should be introduced because he thought that the concepts "were very poorly framed" and "were not accurately going to achieve goals." () He described them as "half baked arrangements that had not been properly thought through." () He has submitted that the transfer pricing system for allocation of costs should be based on a simple percentage formula which is agreed in advance, and only amended where there is an obvious need.()

Mr Targett agreed that transfer pricing assisted with the assessment of the profitability of divisions. He said:

"If it is set up properly it should be set up in such a way that the net result from a division is after transfer pricing. So in other words it is taking the full cost of its funding and the infrastructure of the rest of the organisation that uses it, so the number you see from that division is the bottom line and the real result that it produces. I do not think without proper transfer pricing and those sort of measurements you can actually say that some of the businesses are providing adequate returns or not, because you just do not know." ()

In this passage Mr Targett was obviously talking about transfer pricing of both the cost of funds and the cost of the infra-structure.

The system of transfer pricing that was established in 1988 apparently satisfied Mr Paddison's criterion for simplicity. All funds were transferred into Treasury at the three month rolling average 90 day bank bill rate minus 0.05 per cent and funds flowing from the Treasury to operating divisions were priced at that rate plus 0.05 per cent. The Peats Report which reviewed Treasury operations as at September 1989, criticised the system on the basis that it was over-simplistic.

The basic nature of the system of transfer pricing that was introduced is evidenced by the fact that certain items were excluded from the process of transfer pricing and posted to a "Liquidity Division" which became the domicile for unallocated costs. The Liquidity division was introduced at the same time as transfer pricing for the purpose of accounting for items which had previously been debited, without justification, to Treasury. By way of illustration Ms Meeking gave the hypothetical example of a division spending a substantial sum on a computer in the beginning at a year rather than at the end of the year. That sum would be debited against Treasury. Ms Meeking said "nobody ever knew where the money went. We could never balance." Ms Meeking described the Liquidity division as "... very much a step on the way to try to make the Bank properly account for all of its cash". ()

In the absence of transfer pricing, there should, to use the words of Mr Paddison, have been some other "stable mechanism for sending signals to assist asset generators, people that are lending money (about the Bank's) broad cost of funds." ()

Accordingly, even after the transfer pricing system had been introduced in 1988, the simplistic nature of the system and the existence of the Liquidity division meant that there remained a potential for the profitability reports to be misleading. The Bank still had not introduced transfer pricing of the overhead costs, or to correct for capital and provisioning effects.

7.5.4.2 The Relevance of Transfer Pricing to the Allocation of Resources

Reported profitability was important because it is common ground amongst all the witnesses that the Bank was profit driven. The reported profits were important for the assessment of performance and also the determination of salaries, bonuses, promotions, and the allocation of resources to different divisions. For example, in the minutes of a prudential consultation, dated 12 September 1986, there is a record:

"Mr Marcus Clark said that Mr Matthews was currently dividing the Bank into Retail, Corporate and Treasury areas, each of which is to operate as a profit centre and will not be allowed to grow if it does not contribute to profit." ()

This statement had been made two years before the introduction of transfer pricing. It demonstrates the potential for the mis-allocation of resources between 1986 and 1988.

The absence of a system of transfer pricing and divisionalised management accounts until late 1988 meant that the management information of the Bank prior to that date was deficient. Consequently, the Bank was not in a position to effectively allocate its resources, or price its products. Even after the transfer pricing system was introduced in 1988, there was still a potential for reports to be misleading because of the rudimentary nature of the system, and the existence of the Liquidity division.

A proper pricing of the funds that are made available to operating divisions is necessary for an assessment of both the profitability of particular transactions and the profitability of particular divisions. Without that information, the Bank's business could not be properly managed.

7.5.4.3 The pricing of funds used in lending transactions

Transfer pricing can also assist with the pricing of lending transactions. While some people argue that pricing should be driven by the conduct of competitors, the preponderance of the evidence is to the effect that calculating the cost of funds is essential in order to calculate the amount of profit being derived from a particular transaction, or indeed, to know whether the transaction is profitable at all. Unless the Lending division of the Bank knows the total cost of the funds it is providing to customers, it is not possible to determine the profitability of a particular transaction.

There is clear evidence that pricing in the State Bank was carried out by reference to market forces rather than the cost of funds. There is also evidence that the first ALMAC acted as a pricing committee. It knew the weighted average cost of funds and what it did was to consider the cost of funds, what the market was doing, and set the lending rates.()

Mr Mallett said that the Corporate Banking division was conscious of pricing issues but "was more conscious of competitive issues. If you wanted to do the deal you met the market" with the consequence that the Bank might on account of this policy have entered into lending transactions which were unprofitable.()

To be successful, a business must be competitive in the market and the pricing of loans must ultimately be a commercial decision. In making such decisions there are no doubt many factors which must be taken into account. Competitor behaviour is obviously an important factor and cannot be disregarded. It should not be the only factor.

In my opinion the lending divisions should, in pricing transactions, have given more attention to the Bank's cost of funds .

7.5.4.4 The effect of the absence of transfer pricing on the reported divisional profits

Ms Meeking gave evidence that, while he was in charge of Retail Banking, Mr Paddison rejected the introduction of transfer pricing into the Retail Banking division of the Bank. Mr Copley has given evidence to the same effect.() The Retail Banking division had its own Asset and Liability Management Committee and fixed its own rates. It was not, however, debited with administrative overhead such as the cost of the information systems or the Personnel department. Retail Banking was a big user of those services.

Ms Meeking has suggested that Mr Paddison rejected the introduction of transfer pricing to Retail Banking "because it would have been shown the Retail Bank was not particularly profitable". () Initially, the Retail Banking division had been self funding by reason of the fact that it had a net surplus of customers' deposits. Ms Meeking that said some time after transfer pricing had been introduced into the Bank, interest rates grew sharply, and when Retail Banking was forced to borrow money through Treasury the true position was revealed.() She said that the margin charged by Retail Banking was one which the industry would regard as less than adequate, and that Retail Banking only appeared to be profitable so long as interest rates were relatively stable, as long as the liabilities (customer deposits) of Retail Banking exceeded its assets (advances to customers), and real costs, such as the infrastructure costs of personnel, computing, and imputed rent, were not attributed back to the division.()

Ms Meeking said "Retail Banking makes a very big spread, and if you don't write the costs of Retail Banking back into Retail Banking, it either looks absolutely wonderful or just very good".() The allocation of costs to the Retail Banking division was obviously a matter of contention between her and Mr Paddison.()

When asked why nobody had been able to point out the fact that the reported profit of Retail Banking was illusory, Ms Meeking said:

"In New York, in late 1989, when we had our conference, Steve Paddison stood up and told our conference Retail Banking made a return of 33% on capital. Probably to my detriment, I stood up and said that was fictitious, and that there were some $7M monthly recurring costs that were not being attributed anywhere and probably could largely be attributed back to Retail Banking.

As far as I am concerned it was never in Steve's interests to publicly acknowledge those costs, and for whatever reason, I don't think it was ever probably understood, as I say, until Michael Hamilton came into the Bank and then started to make some headway, I think between Michael and Trevor, in having those costs taken back to where they should be." ()

In a subsequent interview, Ms Meeking confirmed her earlier evidence, and said:

"... I had major concerns about the way that the Retail Bank was managing its interest rate risk, its liquidity flows and with its management in general ... reporting that it was very profitable when it wasn't." ()

Mr Mallett agreed with Ms Meeking's concerns about having costs attributed back to the divisions where they belong.() Those costs, in the case of the Retail Banking division, were of the order of $7.0M a month.()

It was Ms Meeking's view that the failure to transfer price overhead costs to the Retail Banking division gave rise to losses. She said, by way of example, that if the costs of a new computer facility had properly been attributed to the user departments, losses would have been demonstrated. She also thought there were losses on fixed rate commercial lending incurred by the Retail Bank until it finally agreed to allow Treasury to take on the interest rate risk it generated by those loans.() She kept a list of the losses at the time, but that list is not now available. At the time of giving evidence, she was unable to recall the amount of the losses other than to say that the order of the losses "was quite significant. Certainly tens of thousands. It may well have been hundreds of thousands ... I think it would have been hundreds of thousands but I just can't remember at all now." ()

It was suggested to Mr Targett that there was evidence that in the Retail Banking division as there was no transfer pricing of overhead costs the reported profit of the Retail Banking division was simply the margin that was achieved on the interest rate. Mr Targett said he had become aware of that fact. He said:

"I became aware that that was an issue and, in fact, - when we ... looked at the retail bank and took into account the bulk of the overheads which obviously were there to support the retail bank, it was a pretty marginal business so that would have sent a signal if we had done that in the first place. The other thing we became aware of ... the retail bank was not actually funding itself. It had more assets than liabilities, and we assumed with the franchise we had in South Australia that it would have helped to fund the Bank overall, that would have sent some sort of signal as well in terms of its asset growth." ()

Mr Targett agreed that the position with respect to Retail Banking could have been identified if asset and liability management had been carried out in a better way. In particular, he thinks the Bank should have focussed on the infrastructure costs, and if ALMAC had a breakdown of the asset and liability profile by division, the Bank could have discovered sooner that the Retail Bank had become a net borrower from the wholesale market.

Mr Targett was of the view that the reported profit in Retail Banking was "clearly misleading" with the consequence that the allocation of capital to that division may have been misplaced. In addition the rewards enjoyed by staff in the Retail Banking division may have been distributed on a false premise. ()

Mr Paddison has made a lengthy response to these claims. He correctly points out that the Retail Banking division was subject to the same accounting regime as the rest of the Bank. The difference, however, is that the Retail Banking division was the principal beneficiary of the fact that items of overhead were ignored when profit reports were prepared, because the Retail Banking division was by far the largest consumer of overhead expenses. Mr Paddison has also submitted that it is inappropriate to criticise either the Retail Banking division or himself because of the Bank's accounting policies. On its face that submission is correct, but it must be remembered that Mr Paddison was, at all relevant times, a member of the Bank's Executive Committee, and if the Bank's accounting policies were inadequate he can not completely disclaim responsibility.

Mr Paddison accepted that the Retail Banking division does have a higher proportionate consumption of retail costs.() He believed, however, that that fact was understood. His recollection is that nobody had come to terms with the issues in their fullest and broadest sense, and he can not recall anybody ever opposing transfer pricing in general.() He could not recall Ms Meeking raising any concern about this issue with him either in New York or elsewhere.()

Mr Paddison has also submitted that Retail Banking could have absorbed the entire overhead of the Bank and still remained profitable.() He claims that the reported profit was not misleading, because it was always clear exactly what the basis of reporting was, namely operating profit before overhead allocation of the general overheads.() He says that the figures were reported in the way that the Bank's financial policy dictated and that the basis on which the profit was being reported was obvious.() He acknowledges that the biggest beneficiary of the inadequacy in the accounting system was the Retail Banking division, because it absorbed the greater proportion of the overheads. Mr Paddison says that was always acknowledged by himself and "you would have had to be an extremely naive person at a management or board level not to have come to what is after all a common sense conclusion."() He pointed out that the financial plan was under the chief financial officer, not the Retail Banking division, and that "Retail Banking could not stack the deal. It just lived with the deck. If the Bank had an inbuilt bias built into it that was to Retail Banking's benefit".()

Ms Meeking has given evidence to the effect that because the deficiency in the way the divisions reported profits had existed for so long, no adjustment was likely to be made by the Board for the errors that were built into the system.() When items of unallocated overhead were allocated back to divisions in mid 1990 it was agreed that the Retail Banking division should be debited with approximately 90 per cent of those costs.()

The evidence is that capital was allocated, and rewards to individuals determined, by what was incorrectly reported as profit.

7.5.4.5 Pricing the Funds used in the Corporate Banking Division

Ms Meeking said that when she first joined the Bank, Corporate Banking did not actually pay for its funds, although there were guidelines about what were acceptable margins. If Corporate Banking required funds, they were provided by Treasury, but Corporate Banking did not always know what the cost of funds was. She said:

"Their concern would have been getting a certain margin over Bank Bill Rate. They didn't know whether the funds were actually costing the Bank the Bill Rate or 1% under the Bank Bill Rate. ... I think the Corporate Banking assumption was that the Bank would be making the difference between the Bank Bill Rate and the margin they charged. But in Corporate Banking, it's probably also fair to say that the spread was driven as much by market forces as an internal policy of saying: we're happy with 40 basis points or 60 basis points. The fact was there was a very competitive corporate lending market and the Bank, as a matter of policy, wanted to be part of it. So, to some extent at least, it was a matter of accepting what the market would offer."

In consequence there was either matching or under-cutting of competitors.()

When asked whether the focus was on creating assets rather than measuring the profit to be derived from transactions, Mr Mallett said:

"... All I know is that from my perception was that in the early stages Corporate was primarily concerned with positioning itself in the market, getting a name, and in that process one of the only competitive - the only competitive strategy it could adopt is being the lowest price." ()

He said that the Manager in charge of Corporate Banking:

"... was conscious of pricing issues, but I think he was more conscious of competitive issues. It you wanted to do the deal you met the market."

He was asked whether "the risk in that approach is that you might be doing deals which are unprofitable?" and he replied: "Absolutely." ()

7.5.4.6 Practical difficulties caused by pricing practices during 1990 and 1991

Mr Targett gave evidence of a concern that he had, at the time he joined the Treasury, that Treasury did not have input into pricing. He tried to become a member of the Lending Credit Committee "so I could start to see the types of deals coming through, because it was my opinion the lenders didn't understand the price, didn't understand how the relativities of their pricing were stacking up against like assets in the market". He also said:

"Pricing is something I believe the organisation has got badly wrong, and even to the day I left the Bank I still feel we are struggling with it." ()

He gave evidence of "deals" on which the Bank was actually losing money with respect to the time at which that transaction was entered into.() Mr Targett referred to a transaction involving a customer of the Bank which, for the purpose of maintaining confidentiality, I will refer to as XYZ Ltd, as an illustration of his view that Corporate Banking was not lending effectively or efficiently. He said:

"... That particular deal was one which we thought was particularly badly priced and it came about the time we were protecting our pricing in the market by buying paper back so it was a large deal - I think it was about $250 million, from memory, and it was poorly priced for the term - and it was one that just brought some of the matters between Treasury as the funding arm of the Bank and the lending arm of the Bank a little bit more to a head." ()

He also said:

"I felt all of a sudden, because the market pricing was moving, our lenders didn't really understand our price of funds was going up and they are lending at the same margins. Our spread was narrowing ... I was saying: guys, you've got this illiquid asset growth on the books but it's not really giving us a good return. If you look at liquid assets that you can buy in the market, you might get a capital gain, liquefy it tomorrow and make a bigger profit. How can you just tie in these things. We believe we are losing money." ()

Mr Targett was asked whether there had been any discussion about the appropriateness of the transaction with XYZ Ltd before it was consummated, and he replied:

"Yes there was. One got the impression that it was a deal that was passed across to us by SAFA and it was almost as if people had made the commitment to do it and so therefore we were stuck with funding it, so we then took a slightly different tack in that we went back to the dealer arranger who was Bankers Trust and asked them if they could - we told them about our problem confidentially and said could they fund the deal for the initial period while we got our house in order and they agreed to do that. To me it was a done deal, it was something that people felt they had to do, they had made certain commitments so in the end it was just a matter of making the best of a situation which we did not particularly agree with." ()

Mr Targett said he was opposed to the transaction because of the timing of it, and the size of it, and the difficulty in funding it.() Mr Targett also said that Treasury was, at the time, trying to make the point that "the balance sheet was a little bit bigger than we felt the Bank was able to fund at the right sort of benchmark".() The transaction was entered into at the same time that the Bank was buying back its own paper in the market. The transaction involved the Bank tying up funds for five years at a return of thirty seven basis points above the Bank Bill Rate. At that time, the Bank was paying sixty five basis points over the Bank Bill Rate for capital which had been provided by SAFA. Mr Targett said:

"... Some of our capital was priced at 65 over [the Bank bill rate] so a deal like that is very questionable, but not only that, it was illiquid, which meant we could not get it off the balance sheet any time, we were stuck with it for five years and we tried to say Corporate Banking: look, you can go out there and buy a SAFA bond that is liquid, out along the yield curve at a very similar return. So the question is: if we could do that and liquidate at any time to create liquidity and get the same sort of return why are we putting our money into that sort of thing?" ()

Mr Targett said that the problem was not necessarily that the transaction would produce a loss, but that the transaction compounded problems which existed in other areas of the Bank at the time. He said:

"It did not produce a loss and it may not produce a loss but in terms of comparable assets to that, that were more liquid, we felt that if we were going to go out and generate some small marginal income off the back of our funding base that we probably needed to do it by buying liquid stocks rather than investing in illiquid stock to manage interest rate risk." ()

Mr Paddison defended the transaction with XYZ Ltd on the basis that the risk rating of that transaction which was secured by bank Letters of Credit at 20 per cent, resulted in a margin of thirty five basis points giving rise to a yield of 1.5 on a risk weighted basis, which he said was a very healthy margin.()

Whether Mr Paddison is right or wrong is of secondary importance. The important feature of the transaction, for present purposes, is that the refusal to pay attention to what was being said by the Head of the Bank's Treasury illustrates the low priority given by the operating divisions to the need for asset and liability management.

Mr Targett said that some internal seminars were held to explain the importance of having regard to the cost of funds, but that the lending divisions either could not, or did not want to, understand. He said:

"I wasn't involved in pricing. Deals were shown to us at the end and (we were told): here you are, you have to fund it. But we were trying from I suppose the middle of last year [1990] through to about some time this year. We were certainly making a fair bit of noise, because we could see the pressure developing on the funding side of the domestic market and we were trying to get these guys to slow their growth on the asset side. If they were lending, to try to get an appropriate return. We just felt they didn't understand pricing, they didn't understand our costing." () [Emphasis Added]

More particularly, Mr Targett gave evidence that transactions were not being priced by reference to a yield curve. The lenders had always assumed that the organisation could borrow from the wholesale markets at the bank bill benchmark rate. His evidence to the Investigation was:

"[Mr Targett] ... We weren't pricing into the deal the cost of committed funding across a yield curve. We were simply allowing people to borrow whatever they wanted from the Treasury at the end of the day at that bank bill benchmark rate. ... The problem is all of a sudden when you get a time like last year (1990), when the balance sheet is too big and you need to liquefy some of the assets. You might find you have done all your lending on a committed basis. You can't liquefy anything. You are continually having to rollover the short terms to make ends meet.

Q. That makes it very difficult to downsize the assets on your balance sheet very quickly.

Mr Targett: Absolutely, that's the problem the organisation is having now. It's lent to a lot of people who don't have the ability to repay. That is the part of the argument I had, that this non-liquid lending is only making the problem worse. We need more of the liquid type stuff to make sure we have the right sort of balance. Those types of decisions should have been made in the early days by an effective asset management committee, but all we did was became the balancing item in Treasury. We were trying to more and more educate the people, so we got to the stage of saying: guys, we got this badly wrong." ()

Mr Targett felt that there was a view amongst the lenders that, because of the Government Guarantee, Treasury could just keep going to the market to borrow more money at the bank bill rate. He said "clearly the asset generators were out there developing business and we were left to fund it".() On his evidence the matter was clearly one of concern to Mr Targett. He said:

"In fact we did some work towards the end of my time in the Bank trying to educate Corporate Banking as to the Bank's cost of funds in the market, how assets that were a similar quality to ours and others were trading in the market and they should be aware of building in, if you like, a liquidity premium into their term lending so that we got a better balance in our short term, long term funding and those sorts of things and I guess we really had a bit of an uphill battle whether they basically said: well, we've got a prices deal at market and at the end of the day what that meant is we probably put some things on the books that we should not have and that we mispriced as well." () [Emphasis Added]

He clarified that evidence and explained that the Corporate Banking division entered into some transactions that were, in fact, unprofitable, and destined to be unprofitable from the beginning. That is a matter of which Mr Targett had become aware. He said:

"We had noticed ... some very, very skinny margins on deals and in fact at one stage I asked if I could sit on the Credit Committee just to show the Credit Committee some of the deals that were coming up and how they were priced relative to similar credits in the market just to prove that people were mispricing deals, in my opinion. So some of the deals that were put on the books for term, ie, you know, committed outside a year, clearly in terms of measuring those against our cost of funds for similar periods were just in no way the sorts of things the Bank should have been doing." ()

Up until late 1990 Treasury had always been able to raise the necessary funds. In about October 1990, however, Mr Targett and Mr Paddison thought liquidity was going to develop into a problem. Mr Targett said in his statement:

"We felt that we could not afford not to put the whole asset and liability structure of the Bank together and we needed a team of people to get the work done, and take the time to do it." ()

He also said:

"The other concern we had within Treasury was that people were writing assets that really weren't appropriate given the funding climate for the Bank. We wanted to bring the whole thing together so that people could see the whole picture, rather than continually lending money when we were having trouble funding it at the right price." ()

These concerns are more fully amplified in his statement. What they demonstrate is that it was not until late 1990 that the Bank had taken asset and liability management seriously. Even then there was a reluctance by the lending divisions to pay proper regard to the cost of funds.

The culture of not paying regard to the cost of funds which had troubled Mr Hazel was beginning to take its toll.

7.5.4.7 Conclusions with respect to transfer pricing

On all the evidence before me, it is clear that the Bank was driven by a desire to grow and to achieve profit, in particular, short term profit. Mr Targett's evidence, which is largely uncontradicted, together with the other evidence to which I have referred, establishes that the pricing of lending transactions was done, not in a way that conformed with the requirements of asset and liability management, but in a way that was predominantly market driven. There is evidence that the deficiencies in the Bank's pricing practice did give rise to actual losses. There were the losses identified by Ms Meeking; quite possibly the XYZ Ltd transaction referred to by Mr Targett would have also resulted in a loss. No doubt there were other losses as well. This Investigation has not attempted to quantify the amount of the losses.

On all the evidence, I conclude that the lack of a proper transfer pricing system had the effect of distorting the profit reporting in the Bank, particularly with respect to the Retail Banking division.

While transfer pricing is a contentious matter, I accept the evidence of Ms Meeking and Mr Targett on the topic and have formed the opinion that the Bank should have introduced transfer pricing much sooner. This conclusion is supported by the fact that transfer pricing was eventually

introduced, and is still carried out and regarded as being important. In my opinion, the Bank should have adopted a policy of requiring the margin on lending transactions to be assessed by reference to the cost of funds. It may be that those things never happened because of the policy to price transactions by reference to market forces. Nevertheless, even if it was appropriate to have a policy to price transactions according to market forces, that did not negate the need to be aware of the cost of funds and the profitability of each transaction.

In making these findings, I have not imposed artificial standards. I have done no more than to adopt requirements which had actually been identified by Bank personnel, but which were not put into effect either because of the absence of appropriate systems and procedures, or because of resistance from other personnel in the Bank.

The question of pricing funds can be reduced to a simple proposition. In any business the vendor of a commodity needs to know both the cost to the business of the commodity and the required margin on that cost in order to determine whether the sale price is sufficient to return a margin of profit. The Bank ignored this fundamental business principle which in my view, is an accepted principle of financial management (Sub Section 15(2) of the State Bank Act). It did not pay heed to the statement of Mr Clark in his memorandum to the Board on 28 June 1984, when he said:

"Of vital importance to the new bank is the management of an interest spread - the difference between what we pay for our money and what we lend it at." ()

In connection with the practice of pricing loans by reference to market forces, rather than to the cost of funds, Mr Paddison said that "it is no good pricing off your cost of funds if your competitors are more cost effective in the raising of funds and they have got a pricing advantage to you." () There is an obvious problem with this approach. While it may, for special reasons, be appropriate to price transactions according to market forces in isolated cases, it is clearly dangerous to price transactions according to market forces without reference to the cost of funds on a permanent basis. The danger is that the accumulation of unprofitable transactions will erode the profitability of the Bank, and whether the business of the Bank will be profitable in the long term is left open to chance. Also, the pricing of transactions by reference to market forces without regard to the actual cost of funds amounts to a complete abdication of the need to manage the Bank's business wisely. It completely ignores the fundamental principles of asset and liability management and ignores the responsibility imposed on the Board by Section 15 of the State Bank Act to manage the affairs of the Bank in accordance with accepted principles of financial management and with a view to achieving a profit.

In all the circumstances I am satisfied that there was no check on lending officers who, in order to attract business, priced transactions at unprofitable levels. If an unprofitable transaction involved the use of disproportionate front end fees, the unprofitability would not be immediately apparent. If the credit risk in relation to a proposed transaction was not properly assessed, there was the potential for a bad debt, but no prospect of the Bank ever making a profit out of the transaction.

If proper systems had been in place, the Board and senior management should have been alerted to the fact that some of the transactions which the Bank was entering into were of no benefit to the Bank at all and were indeed potentially detrimental.

7.5.5 MARKING ASSETS AND LIABILITIES TO MARKET

In the absence of some specific requirement, whether assets are marked to market or not is a matter of accounting policy.

The procedure involves valuing assets and liabilities at their market value from day to day. The process is to be contrasted with more traditional accounting policies which record the value of assets on the basis of cost, or, if the asset accrues income, on a cost plus accrual basis. The differing approaches can give rise to vastly different values for the same asset. Indeed, one method may report that a portfolio has made a profit, while the other demonstrates a loss.

If a Bank does not mark to market, there is the potential for a hidden loss or profit to be realised on the disposal of the asset or liability. If the assets and liabilities are marked to market, then the market value of all assets and liabilities is known from day to day. When expressed in this simplistic way the arguments in favour of marking to market appear compelling. There are, however, arguments against marking to market.

Whether the Bank should mark assets and liabilities to market was at one time a contentious issue within the Bank. It was also the subject of contentious evidence before the Investigation, but like other areas involving complex accounting concepts, much of the apparent conflict may ultimately be a result of generalisation or looseness of expression with the consequence that witnesses may, on that account, have been at cross purposes.

It is not appropriate to mark all a bank's assets and liabilities to the market. Ms Meeking has explained that it is generally accepted that the accrual method is appropriate for stable long term traditional floating interest rate portfolios, where assets and liabilities are held to maturity. On the other hand, marking to market is appropriate for the Treasury area where assets and liabilities which are fixed for differing terms, are actively traded, and opportunities for arbitrage frequently arise.() In the Bank, the foreign exchange portfolio was marked to the market at all relevant times. That was done using the Kapiti software. It is not appropriate to mark a housing loan portfolio to the market, and it is not usual for banks to mark their corporate lending portfolios to market, although there is no reason why that could not be done if appropriate computer software was developed.()

The debate which took place in the Bank as to whether a policy of marking to market should be adopted was really confined to the Treasury portfolio.()

The Bank now supports the concept of marking the Treasury asset and liability portfolios to market, but submits that it is not appropriate to mark to market asset and liability portfolios outside of the Treasury.() That submission is consistent with the evidence before the Investigation, and I accept that as a correct statement of contemporary banking practice.

It has not always been universally accepted that the Bank should mark its treasury asset and liabilities to the market.

Mr Clark gave evidence:

"So when I came to Adelaide I said: let's start off on 1 July 1984 with everything marked "to market" and then that is to be followed every 30 June after that and we did bring it down in all the adjustments of putting the two banks together on 30 June 1984. Now, to my knowledge, that was the policy of that bank and should have been followed as at 30 June each year". ()

Mr Clark's policy of marking to market on 30 June each year is something which falls mid-way between true marking to market, whereby assets and liabilities are adjusted daily, and the traditional cost accounting procedure. As appears from the evidence set out above, it was Mr Clark's belief that assets were, in fact, marked to market on 30 June in each year(); but his belief is contrary to other evidence as to what in fact happened.

A policy of marking to market the Treasury portfolio was introduced as a consequence of the initiatives of Ms Meeking. Ms Meeking said that she met with initial opposition to the introduction of the policy. She said that Mr Copley and Mr Matthews of the Finance department both spoke to her, and resisted the introduction of marking to market some long term assets, such as government bonds, which were in the portfolio.() Ms Meeking strongly believed that these assets should be marked to market. She said:

"I raised it ... I thought we really did have to mark it to market. Kevin Copley indicated that he wasn't so sure that would be a good thing, because it was not cost accounting - the conservative historical cost accounting that he felt the Bank should be adopting and Ken Matthews was agreeing with that position." ()

Ms Meeking said that while Mr Copley resisted marking to market initially, he came around to it in the end.()

Mr Mallett also gave evidence that Mr Copley was opposed to marking to market.()

When Ms Meeking started in the Treasury, it did mark its foreign exchange portfolio to market using the Kapiti software, but the remainder of the Treasury assets and liabilities were not marked to market. Ms Meeking has told the Investigation that they started work on marking the short term money market portfolio to market, using Kapiti, in September or October 1987.() The short term money market portfolio was marked to market as from 1 July 1988. The system needed a lot of refinement to bed it down over the ensuing months. Treasury officers then directed their attention to the capital market activity/swap book. Following enquiries, a software package was purchased from the United Kingdom, but that was found to be inadequate.() At about the same time, there was an awareness that the Treasury could profitably trade the fixed interest book but Ms Meeking was not prepared to do that without the ability to mark that to market.() After an investigation into the suitability of the available computer software, it appeared that no available system suited the needs of the Bank, and a decision was made to develop the Bank's own software.() The result was the Heaven software.

It was not until the latter half of 1989 that an overall policy of marking the Treasury assets and liabilities to market was implemented.() The policy had still not been made fully operational by the time Mr Targett assumed control of the Australian Treasury, at the end of 1989.

Mr Mallett said:

"Mark to market was primarily Julie's work. Julie [Meeking] went through the enormous pain and effort of systems, mental conceptualisation of bringing the Bank into a mark to market position for its particular response, and she did an enormous amount of the work." ()

One of the benefits of marking a portfolio to market is that it makes it possible to trade the portfolio and monitor the results of the trading. Mr Mallett gave evidence that marking to market was "absolutely essential" to run a trading operation.()

Mr Paddison gave evidence that at the present time:

"There is universal agreement that mark to market is essential on a trading portfolio ...

There is universal agreement that marking to market to monitor funding performance and to monitor what the funding portfolio looks like so you can manage it is essential, but there is still - and I believe in the profession even amongst the specialists - a lot of argument and debate about whether the long term funding books should be marked to market ..."()

Ms Meeking said that she was not prepared to trade with the portfolio until the capability of marking to market was introduced and that there was a significant opportunity lost in not having that capability.()

Mr Targett said that during the two months when he relieved Ms Meeking, in December 1988 and January 1989, the Treasury portfolio had not been fully marked to market. He said:

"At that time, the accounting standard was to do it on an accruals basis and because it was done on an accruals basis it showed a better result than would have been achieved doing it marked to market." ()

Mr Targett said that it was not until about the end of December 1989 that the Bank adopted mark to market on the whole of the portfolio.() That is consistent with the evidence of Ms Meeking.

Mr Targett regards marking to market as something which is essential in a treasury. He said:

"I think in treasury operations it is essential ... it has become a market standard for the major players over recent years because it does not allow people to ... take risk further out for the short-term gain. It gives a truer picture of the real value of the portfolio in question." ()

Ms Meeking said that the initial resistance to marking to market was based upon a suggestion that a lack of flexibility would result.() If a portfolio is not marked to market it is possible to selectively realise profits on particular assets while leaving a loss on the corresponding liability undisclosed until maturity of that liability.() Ms Meeking said that the purpose of marking to market is to assess the value as a whole of a portfolio which can be made up of hundreds of different mismatched instruments.() She agreed that if you don't mark to market you can end up with a quite significant distortion in the accounts. Marking to market is an essential tool in the management of complex portfolios like the risk management portfolio.() Furthermore, if a portfolio is not marked to market there is an ability to manipulate the short term reported profit position.() Ms Meeking said:

"I was aware that the practice had gone on where Mr Clark used to come and ask for more profits out of treasury and someone would find a bond or something that was in the money, sell it and post the profits ... that could happen without mark to market and it couldn't happen with it." ()

Ms Meeking told the Investigation that Mr Hazel had made her aware it had happened at Mr Clark's insistence when "he needed an extra couple of million". She said that "without mark to market, the obvious place to get it is Treasury." () She also said that Mr Clark contacted her by telephone at the end of one year, and asked whether the Treasury "couldn't bring more profit out", to which she replied there was nothing she could produce.()

Ms Meeking said that there was evidence in the portfolio that profits had been extracted selectively and she was never in any doubt that it did happen.() The consequence of the practice of selectively realising assets is that the corresponding losses will only emerge over time or when the book was fully marked to market.()

In the broader context of this Investigation, the significance of this evidence is that it illustrates the ability of the Bank to report profits that were illusory.

Mr Targett confirmed the effect of Ms Meeking's evidence. He said that the fact that the Bank did not mark to market at that point in time did not give rise to any short-term problem but "it simply meant that with all other things being equal, at some stage down the track the Bank was going to pay for the short-term gain that it took on that particular portfolio ... The real problem was potentially if anything did not change you had a portfolio that was negative down the track." ()

In 1989, a part of the Bank's Structured Finance and Risk Management portfolio was sold and a loss realised. This loss was required to be brought to account through the Bank's Profit and Loss Account. At the time, Ms Meeking was criticised for allowing this to occur. A great deal of evidence was given about the matter. Mr Paddison said his concern "was that she (Ms Meeking) did it unilaterally and without giving people the opportunity to work through the implications ... and I believe that her action in that regard was well motivated, but was well less than carefully thought through." () On all the evidence before me, I am satisfied that the criticism of Ms Meeking was not well founded. Also, Ms Meeking has told the Investigation that her actions had the prior approval of Mr Copley, Mr Paddison, and Mr Mallett, and the realised losses were offset by unrealised (future) gains and resulted from responsible and profitable trading practices.() I accept that statement. Further detailed analysis of the matter would only unnecessarily protract the length of this Report, and it is not relevant to the Terms of Appointment.

Mr Copley denies that he was opposed to the introduction of marking to market.() He said that he was concerned to see that a system of marking to market was introduced across the board, rather than in a piecemeal fashion. Mr Paddison has also given evidence that he was opposed to the introduction of marking to market on a piecemeal basis.

At her most recent interview, Ms Meeking was asked whether the money market portfolio could have been marked to market prior to 1 July 1988. She replied that she did not think so. Ms Meeking said that the Treasury people had moved as quickly as they could, and that any opposition she received was inconsequential in terms of the introduction of the practice. She also said that she did not recall Mr Copley opposing the marking to market of that portfolio strongly, and that his resistance was linked with the introduction of transfer pricing which took place contemporaneously.() In all the circumstances, I have formed the opinion that if Mr Copley did resist the introduction of marking to market the Treasury portfolio, there is no evidence to suggest that his resistance is relevant to the matters which are the subject of this Investigation.

Mr Copley has told the Investigation that he was insistent that the book be totally marked to market at the one time. He says he was opposed to a piece meal mark to market as he believed that it gave the opportunity for results to the manipulated by marking up profitable areas and leaving losses undisclosed.()

There is a conflict between the evidence of Mr Copley and Ms Meeking on Mr Copley's attitude to the introduction of marking to market. It is not possible to reconcile their evidence, and I do not propose to protract the Investigation by digressing to resolve an issue of credibility relating to an ancillary issue.

Many witnesses have given evidence that there was a bias in pricing to structure transactions by including large front end fees, which reduced the margin of interest payable over the duration of the transaction. Mr Hazel said "there is no doubt Tim drove, as I say, very much in pharaoh style - drove the corporate guys to front end fees." () That practice had the effect of increasing profitability in the year the transaction was entered into, but could leave the Bank with an unprofitable transaction for its duration.() Mr Hazel suggested the Bank should cover and amortise the front end fees over the life of the loan. That was done for a time, but, in due course, the policy was reversed.()

The reporting of disproportionate front end fees as profit in the year that a transaction was entered into was a practice which had the ability to distort the reported profits of the Bank. There is a clear inference that disproportionate front end fees were raised for the purpose of increasing the reported profit.

The Investigation has heard evidence that practice of marking to market has another advantage in that it reveals the true position with respect to transactions on which disproportionate front end fees are taken. For example, Ms Meeking said "... If you mark to market that immediately shows the profitability or unprofitability of the particular transaction." ()

Because all the profit on transactions where disproportionate front end fees were being taken was being shown in the first year, it has been submitted to the Investigation by certain Directors that it became necessary for the Bank to grow from year to year in order that the profitability of the Bank could be maintained in subsequent years. If the Bank had a practice of marking assets to market, that would have prevented any distortion of the accounts, because both the front end fee and the subsequent losses would be brought to account in a present value sense.() Nevertheless, because it is not usual to mark the assets of the corporate lending division to market, I am unable to find that the practice of taking disproportionable front end fees was in any way facilitated by the absence of a policy of marking to market. The remedy would have been to amortise anything greater than a normal establishment fee over the life of the loan. That was suggested in evidence both Mr Hazel and Ms Meeking.()

The evidence does not demonstrate any direct connection between the absence of a policy to mark to market the Treasury portfolio and the losses suffered by the Bank. There is, however, a demonstrated absence of a proper asset and liability management function until at least 1988 and probably 1989. The Bank should have marked the Treasury portfolio to market prior to the initiatives which were taken by Ms Meeking from the second half of 1987 onwards.

The absence of a policy to mark to market was something which enabled short term profits to be taken while the corresponding losses remained undisclosed in the books of the Bank, and was, therefore, a matter which contributed to the reported profits of the Bank being misleading. There was also an inability to trade with the portfolio.

7.5.6 CASH FLOW FORECASTING

The Bank's inability to introduce a system of cash flow forecasting has been the subject of much evidence.

The need for a cash flow forecasting system had been recognised by Mr Hazel. It was also one of the objectives of Ms Meeking. Nobody now disputes the desirability of, and need for, a system of cash flow forecasting.

This is another area where looseness of expression in the evidence has resulted in apparent conflict between the evidence and in witnesses often being at cross purposes.

In its simplest form, cash flow forecasting is nothing more than the budgetary process that any well run business should undertake to plan the inflow and outflow of money. Normally the process is confined to budgeting what may loosely be called operating expenses. When asked to explain what they understood the process of cash flow forecasting to be, both Mr Copley and Ms Meeking defined the term in slightly different ways that were concerned with planning the flows of money that were relevant to the Bank's operating budget.() Other evidence has used the term to refer to all the cash movements in the Bank, so that it refers not only to the operational expenses associated with running the Bank, but also the cash flows brought about by the maturing of the Bank's assets and liabilities and other cash flows, which are incidental to the Bank's trading. In this second sense, cash flow reporting forms an important part of the broader task of liquidity management.()

Because of the looseness of expression, it is often impossible to know precisely what different witnesses had in mind when they referred to cash flow forecasting. Unless the contrary appears, I have assumed that the expression refers to cash flow forecasting in the broadest sense, and that there is no difference between "cash flow forecasting", "cash flow reporting" and "cash flow budgeting".

All the evidence is to the effect that cash flow forecasting systems assist with the efficient asset and liability management of a bank, in particular, liquidity management. Mr Mallett said the objective of cash flow reporting is "to make sure you are always in a position to meet your obligations".()

Cash flow forecasting is important for a number of reasons. It enables a bank to time its funding to coincide with the expected need. The greater time a bank has to arrange funds, the greater the opportunity to manage the risk and achieve a lower cost of funds. Excessive liquidity is expensive since a bank will normally earn less on liquid securities and cash than could be earned through lending.

The forecasting of cash flow must be an inexact science because of the variability of the base data.

In Mr Paddison's view, one of the reasons why cash flow forecasting in a bank is useful "is that you manage the reinvestment of your free cash flows much more aggressively so that you are getting maximum value out of the free cash flow." He said another benefit was "that if a lot of your income is accrual you've got to be certain of its recoverability and if it is not cash you've got to borrow the funds. So ... you are looking at the level at which an accrual is building up so that you are having to fund and you've got to worry about the collectability." ()

As a priority, Mr Paddison put cash flow forecasting well behind asset quality information and behind good interest rate, funding and liquidity information. He said that the existence of cash flow forecasting "would not have saved anyone's bacon. It would just have shown that there was a deteriorating trend, particularly in a couple of key businesses. Corporate would have been one and Beneficial would have been the other." () [Emphasis Added]

The textbook "Managing Bank Assets and Liabilities" which is referred to above, contains a Chapter on the subject of "Managing Liquidity". In connection with the management of the liquidity risk and the funding risk, the author says:

"The traditional approach towards the handling of funding risk was the active management of cash and liquid asset holdings. But, with the rapid development of wholesale money markets, first in the US and later in London and the advent of liability management in the sixties and early seventies, regulators and management alike switched their attention to a more dynamic form of appraisal -cash flow analysis. Accordingly, "maturity ladders" were adopted, whereby balance sheet items were placed in the ladder according to an agreed schema which related to the expected timing of the generation of cashflow, and net mis-matched positions were accumulated through time to provide some quantitative measure of a Banks need for liquidity". ()

After discussion of the advantages and disadvantages of the process which he refers to as cashflow analysis, the author concludes, "such analysis is indispensable in providing individual banks with a clear picture of the funding risks they are exposed to".()

The necessity for a system of cash flow forecasting is also enshrined in the Reserve Bank's Prudential Statement D1, in particular, paragraphs 16 and 17.

All the evidence establishes that up until the end of 1990, liquidity was never a problem for the State Bank. The Bank had a very high credit rating, and the benefit of a government guarantee. There was a complacency about the need for cash flow forecasting and liquidity management.

Mr Hazel and Ms Meeking both gave evidence that they recognised the need for a system of cash flow forecasting, but there is no evidence that any positive steps were taken to satisfy that need until late 1988.

There is evidence that the implementation of a cash flow forecasting system was left in the hands of the Finance department and Mr Copley, but that a system was never introduced because the task was too difficult. There is also evidence that Mr Copley was criticised for his department's failure to introduce cash flow forecasting.

Mr Clark's evidence on the subject was:

"I was very concerned about our failure to come to grips with having cash flow budgets. I wanted a cash flow report and I wanted to see cash flow budgeting. I am not sure whether it will be something that I came up with myself or pushed or whether I was alerted to by one or two of the directors. It could have been a combination of both, but there was certainly, from my point of view, a strong push to Kevin Copley to come up in our Operating Review monthly what was our cash position, our cash flows. It was a matter that he was charged the responsibility of doing that, and I became increasingly concerned that we weren't getting an answer to it and that Steve Paddison also, I think, expressed concern." ()

Mr Clark said nobody seemed to be able to come to grips with it, and that it was absolutely critical that the Bank come to grips with the cash. He says that Mr Copley got the job of doing it and that "he got a lot of curry. He used to get criticised by the Executive Committee, I criticised him, we did get stuck into him." ()

Ms Meeking says that Mr Clark in fact instructed Mr Copley, in an Executive Meeting at the end of 1988, to put in place cash flow budgets.()

Mr Copley acknowledges that the bank should have had a system of cash flow reporting. In fact, he gave evidence that he attempted to introduce cash flow forecasting when he first joined the Bank, but that his moves met with resistance. He said:

"... when we first introduced cash flow forecasting nobody in the Bank knew anything about it. When I first talked about cash flow forecasting people looked at me with blank expressions on their face and sort of said: Whats that? This is a bank. We don't ..."()

Mr Copley said that he thought it was important to have it, and he had another employee develop a cash flow model for the year ended 30 June 1989. Six months was spent on the project. That model has been made available to the Investigation, and corroborates Mr Copley's evidence. Mr Copley said that the model was never put into effect. It was presented to the Executive Committee, but was not pursued because of opposition from Mr Paddison and Mr Mallett.()

Mr Paddison strongly denies that he or anybody else opposed Mr Copley's proposal.() His recollection is that it did not occur because tracking the cash would have involved a huge effort.

Mr Copley said that it was pointless developing the model further, and the employee who had been assigned to the task was moved to another job. The project then remained dormant until about September of 1990. Mr Copley said that the need for cash flow forecasting was then identified as being a matter of high importance.() He gave evidence:

"... the person I had doing it was taken off to do another job, and for a period of time ... we didn't take it any further until in about the middle of last year when all of a sudden we can't manage the business because we haven't got cash flow [reporting] and its my fault we haven't got it."()

Mr Copley also said that the steps he took to develop a model in 1988/89 met with a lack of co-operation from officers in the Treasury department.()

While Mr Copley agrees that he was criticised for not introducing cash flow forecasting, he says that did not happen until "the second half of 1990 when others suddenly became aware of its virtues".() There is no firm evidence to suggest that Mr Copley had been criticised prior to that time and I accept his submission. He says that Mr Clark's evidence about his inability to introduce cash flow forecasting is correct in so far as it relates to 1990, but that evidence overlooks Mr Copley's own initiatives when he started with the Bank.

In fairness to Mr Copley, it must also be said that there is no evidence that he received appropriate support from other senior executives or the Board. Mr Paddison said that, the introduction of cash flow forecasting required more resources than Mr Copley and the Finance department had available to them. He said it required work in other places and was "a massive undertaking." ()

Ms Meeking said that, had a decision been made to adopt cash flow budgeting, there would have been considerable work to prepare the information systems to get them to the point where it could have been done, but she did think it could have been achieved with the resources that the Bank had.

The installation of a system of cash flow budgeting for operational expenses is something which falls clearly within the province of the Finance department, but a system of cash flow reporting which included the maturity of the assets and liabilities of the Bank could not have been implemented by the Finance department alone. Much of the necessary information was within the province of Treasury or other divisions of the Bank. For a full system of cash flow reporting to be introduced all the divisions had to co-operate, and be co-ordinated. The task required more than the resources of Mr Copley or the Finance department alone.

Mr Paddison put the two requirements into a correct perspective. He said that, in terms of managing the Bank, one of the key elements of cash flow reporting is to ensure that the Bank remains liquid and able to meet demands on its liquidity. He said:

"... when you are talking about practical liquidity management at the treasury level, the quantum of actual cash expenses that have to be budgeted for pale into absolute insignificance compared to risk management aspects of making sure liquidity profiles are assessed and evaluated in terms of liquidity demands that might be put on a bank in a crisis situation".()

He pointed out that, although budgeting and forecasting for the normal cash operating expenses is important, that is different from the risk management overall.() He said that cash flow forecasting was important, but nowhere near as important as liquidity management.()

Mr Paddison said that he regards the project that Mr Copley undertook in 1988/89 "as more a source of funds application and not really as a liquidity management system, and nowhere near the sophistication we required ".()

Mr Mallett said the responsibility for the introduction of cash flow forecasting rested with the Finance department. It was not a Treasury area.() He says that Mr Copley was not against it, but the end result was it was just too hard.()

On the basis of the evidence described in this Chapter, I find that the Bank should have had a system of cash flow forecasting. I find that the need for cash flow forecasting was recognised within the Bank no later than 1987. There is a great deal of evidence that the failure of the Bank to implement such a system lies with Mr Copley.

On the evidence, I find that the reason why a system of cash flow forecasting was not introduced was simply because it was beyond the resources of the Finance department, which did not receive the necessary support from senior management and other divisions of the Bank. It is also a reflection of the fact that there was nobody who had overall responsibility for the asset and liability management of the Bank.

When it became apparent to Mr Clark and senior management that Mr Copley and the Finance department did not have the ability or resources to introduce cash flow forecasting, further steps should have been taken, such as employing an outside consultant, or deploying people with the necessary experience within the Bank. It is clear that other institutions had systems for cash flow forecasting, and its implementation within the State Bank should not have been an impossible task.

At the end of the period under examination, a full cash flow forecasting system had still not been implemented.

The absence of a system of cash flow reporting is not of itself a direct cause of the losses which are the subject of this Investigation. Cash flow forecasting, however, is relevant to Liquidity Management which is discussed below. I accept evidence given by Mr Paddison that cash flow reporting would have picked up the acceleration of non cash income in Beneficial Finance. If cash flow reporting had been in place, it would have enabled the State Bank Group to be managed in a generally more informed way. I also accept the evidence of Mr Paddison that cash flow reporting would have enabled better management of the reinvestment of free cash flows.

7.5.7 LIQUIDITY MANAGEMENT

Any bank is likely to have a myriad of transactions on foot at any given time, and, on any given day, there will be assets and liabilities maturing in accordance with the terms of the relevant transactions. In addition, customers of the Bank are likely to deposit and withdraw funds at times which are incapable of accurate prediction. Because of these phenomena which are inherent in the very nature of the business of banking, a complete matching of a bank's assets and liabilities could never be achieved. There are, widely used techniques that enable the liquidity of a bank to be managed.

The object is to minimise the risks which flow from the mismatching of the maturities of assets and liabilities, and to take advantage of profit opportunities that such mismatching produces. Usually a bank will endeavour to fund longer term assets (loans to customers) with liabilities (borrowings) of a shorter term. The risk is that the Bank's liabilities will mature at a time when the Bank does not have funds available to meet those liabilities. Banks can manage this deliberate mismatch in the maturity of assets and liabilities; but such management does require planning.

In the State Bank, the Treasury had the task of monitoring the inflow and outflow of funds in such a way that its uncommitted funds were used to the best advantage, and the Bank could avoid the risk of having insufficient funds available to satisfy its treasury obligations as they fell due.

The Prudential Statement D1 of the Reserve Bank to which I have already referred sets out matters which should be taken into account.

The contents of paragraphs 2.1.9 and 2.2.0 of the Peats Report evidence the absence, in September 1989, of formal policies addressing control over the Bank's liquidity risk. The Peats Report notes that some research into liquidity risk was being undertaken, and recommended that the research include the establishment of a formal policy.

Mr Targett agreed with the observation in paragraph 2.19 of the Peats Report that there were no formal policies addressing control over the State Bank's liquidity risk at the time that the Report was published. He regarded that as a deficiency. He said:

"Yes, it was a deficiency. It was certainly a widely held opinion, including the Managing Director, that as a State Bank with a Government guarantee liquidity was not a problem that was likely to trouble the Bank at any time. I mean, from the point of view of prudent management one would assume that we should have done a lot more work in terms of looking at liquidity. Not only the Bank, although the Report says the State Bank's liquidity, I think it was also the group because certainly Steve Paddison and I talked about Beneficial and we felt that if any liquidity problem was going to occur, and thank goodness it is not, but it might have started from Beneficial rather than something happening within the Bank." ()

Mr Targett said that a liquidity policy was developed in 1990 by Treasury in conjunction with the ALMAC support group. He said that the Board of Directors was not involved in setting up the policy in any way; it was simply informed of the policy before the Reserve Bank was advised of the policy in January 1991. That evidence is corroborated by the minutes of meetings of the Board and the second ALMAC.

Mr Targett said that people looked at the need for a liquidity policy in the State Bank differently from how they would have looked at it in a privately owned bank because of the State Government Guarantee. Nevertheless, his view was:

"At the end of the day I do not think you should really look at it any differently. You have got to make sure that your book is structured in such a way that you can meet your obligations, no matter who your owner is, and we just had not really done that well enough." ()

The need for the Bank to improve its liquidity management was recognised in a memorandum dated 12 January 1990, from Mr Paddison to Ms Kimber, who was head of Risk Management. The memorandum also evidences the genesis of an appreciation of the need to manage assets and liabilities on a Group wide, rather than on a Bank only, basis.

The requirement for Group wide liquidity management was raised again by a memorandum() to a number of members of the Senior Management of the Group from Mr Clark, dated 14 February 1990, which called a meeting for 21 February to discuss a policy to regulate the activity of all members of the group in regard to liability raisings and liquidity management.

The need for a liquidity policy was under consideration throughout 1990. The minutes of a meeting of the second ALMAC held on 2 July 1990 record:

"Liquidity - Policy and Reporting

It was agreed that liquidity reporting would encompass the liquidity policies of Australian Banking, International Banking and the Beneficial Group. This would entail weekly reporting on Australian Banking and a monthly group consolidated position merging the three liquidity policies for graphical presentation to ALMAC and the Board of Directors.

A formal liquidity policy for Australian Banking was approved. The existing liquidity policies for International Banking and Beneficial Finance Corporation were noted.

It was also noted that it is the responsibility of GRM for ensuring that this group liquidity risk position is managed and reported in line with approved limits/policies." ()

On 31 July 1990, the second ALMAC deferred approval of a functional specification for a liquidity reporting system for Australian Banking in order to allow enlargement of the specification to incorporate group operations.() Included in the papers for the meeting of ALMAC was a recommendation, from Ms Kimber, Head of the ALMAC Secretariat, that ALMAC approve a functional specification for a liquidity reporting system for Australian Banking which was attached. The background to the recommendation included reference to the fact that a new liquidity policy for Australian Banking had been approved by the second ALMAC at its meeting on 2 July 1990. The background statement asserted that International Banking was developing its own system for the reporting of liquidity, and that the data from that system would be combined with that from the new Australian Banking system to provide monthly reports for ALMAC and the Board of Directors. Beneficial Finance had no plans to develop such a report because its liquidity policies were expressed in a completely different format. It was noted that "such a report is not critically required by them", and that Beneficial Finance was supplying data for the interim reports produced by the ALMAC Secretariat by manually collecting data from their systems. It was suggested that Beneficial Finance be given assistance to automate the process.()

The functional specification for the liquidity reporting system for the Australian Banking division was prepared by Ms Kimber, and dated 12 July 1990. The introduction to the specification stated:

"This document specifies the functionality required of a liquidity reporting system for Australian Banking division.

The liquidity of a financial institution is its ability to repay its depositors as the demand arises and fund increases in assets. The funds must be available at reasonable prices relative to the general market and in the maturities required to support medium and long term assets."

The objective of the system was:

"To monitor the liquidity of Australian Banking to ensure that it conforms to approved policy limits at all times."

The key functions of the system were to produce a detailed weekly report for the use of Australian Treasury and a summarised monthly report for ALMAC and the Board. The production of graphics for Board presentation, and forecast of future liquidity for Australian Treasury, were other requirements. The business functions served by the system were described as follows:

"The information produced will be used by Australian Treasury in their management of the liquidity of Australian Banking division. The information will assist it to maintain adequate liquidity for prudential purposes and to comply with approved bank policy and a maximised profitability within these constraints.

Monthly reports will enable ALMAC and the Board to confirm that Australian Treasury is acting within approved limits." ()

The evidence suggests that the steps which were being taken in July 1990 to manage the Bank's liquidity were the first attempt by the Bank to handle that task in an appropriate fashion. It is not without significance that the recommendation was deferred to allow enlargement of the specification to include group operations.

Included in the papers for a meeting of the second ALMAC held on 13 August 1990 is a Liquidity Report from the ALMAC Secretariat. The report refers to the decision made on 2 July 1990 and notes that it is the first of continuing monthly reports for Australian Banking, International Banking and Beneficial Finance. The material was provided by a combination of general ledger, the Hogan computer software, and manual reports.()

At the meeting on 13 August 1990, a functional specification for liquidity reporting, which included group operations, was put forward.

A memorandum, dated 4 September 1990, to the second ALMAC from Mr G L Smith, Secretary of the ALMAC Secretariat, noted that, on 27 August 1990, it had been agreed that a review party be formed to examine the design of the proposed liquidity reporting system, and that arrangements had been made with the Information Systems department for an employee of that department to work on the project.()

The minutes of a meeting of the second ALMAC, held 10 September 1990, record:

"Liquidity Reporting System

It was agreed that General Manager, Australian Treasury and General Manager, Group Risk Management, would co-ordinate the liquidity reporting system. General Manager, Group Risk Management, is to investigate the duplication of resources devoted to liquidity reporting. A progress report is to be presented to the next ALMAC meeting on 24 September 1990 ...". ()

The minutes of the second ALMAC meeting, held on 24 September 1990, record that a liquidity report for the month of August was presented and noted.()

The matter of liquidity reporting appears to have next arisen at a meeting of the second ALMAC on 30 October 1990. The minutes of that meeting record:

"Liquidity Reporting

ALMAC members noted an interim monthly report on Australian Banking and Beneficial Finance as at 30th September, 1990. It was recognised that operational liquidity management for the group is the responsibility of Australian Treasury and that liquidity management cannot be viewed by any member of the group in isolation. A group liquidity project team in Australian Treasury is currently recasting the liquidity policy for the group and is committed to complete a draft co-ordinated group-wide policy by 21st December 1990. The objective is to develop system capacity to report on liquidity positions daily ...". () [Emphasis Added]

That minute is informative for a number of reasons. It is the first recognition of the fact that responsibility for liquidity management rested with Australian Treasury. It also acknowledges the importance of looking at the liquidity of the group as a whole.

The ALMAC Secretariat provided a report on liquidity, as at 30 September 1990, to the second ALMAC. The report was still being produced manually pending completion of the automated liquidity reporting system. For that month, it was not possible to consolidate a group position because information had not been received from the London Office and the New Zealand branch by the due date. The observations made with respect to the Group's liquidity as at 30 September, refer to the fact that Beneficial Finance was basically over-lent, and that no policy limits had been set by Beneficial Finance.()

Papers which are annexed to the Statement of Mr Targett evidence work which was carried out during the latter months of 1990 in connection with the development of a group liquidity policy. At page 63 of his statement, Mr Targett refers to a memorandum from Mr A K Smith, dated 22 November 1990, on the topic of "Group Liquidity" and says:

"The memorandum refers to the role which ALMAC should play in the management of group liquidity. From almost my first days at the Bank I felt unsure what ALMAC's framework or focus was. From discussions I had with people in the market, their committees handled things very differently. They looked at all asset and liability growth within the balance sheet. ALMAC was not doing this. As such, we were expressing concern that the focus of ALMAC was not what it should be.

Andrew Smith wanted ALMAC to supervise liquidity policy across the group and he sought a reporting framework within that." ()

Documents which evidence the work of Mr A K Smith, and the proceedings of the second ALMAC towards the end of 1990 show a rapidly growing awareness of the importance of proper asset and liability management, in particular, the management of liquidity. The Bank had been operating for almost six and a half years before anybody within the Bank demonstrated an appreciation of the necessity for, and the nature of, proper asset and liability management. Up until that time, the overall asset and liability management function in the State Bank was without overall co-ordination. The Treasury reacted to discrete demands which were placed upon it. The Asset and Liability Management Committees had charters, but did not fulfil their charters. Global Risk Management also had a part to play, but according to Mr Paddison, whose evidence I accept, it was a failure. As the Peats Report pointed out, there was a need to clarify the respective roles of Global Risk Management, Asset and Liability Management Committee ("ALMAC") and the individual business units. The Peats Report noted there were varying perspectives on the relationship between these groups within the State Bank. Most importantly, no one took an active overview of the process. The Board, the Executive Committee, and the Chief Executive, were in a position to take that overview, but they failed to do so.

A global liquidity policy was considered by the second ALMAC on 13 December 1990 and recommended to the Executive Committee for approval by the Board of Directors. The minutes note the Group's heavy reliance on wholesale funding which comprised around 75 per cent of total liabilities, as at 30 October 1990. The minutes also note that a group liquidity crisis was more likely to arise from an inability to place Bank paper than from a "run" on retail deposits. The meeting accepted a revision to the Business Plan to incorporate new objectives regarding the management and reporting of liquidity and the management of the Group balance sheet.()

Included in the Board papers for the meeting of 13 December 1990 was a recommendation to the Board, prepared by Ms Kimber and supported by Mr Targett, regarding the composition and charter of ALMAC. The recommendation noted that a revision of the composition and charter of the second ALMAC was appropriate following the recent restructuring of the State Bank Group. The proposed objectives of ALMAC were expressed in the following way:

"ALMAC is responsible to the Board of Directors for asset and liability management of State Bank Group, in particular for:

- group balance sheet structure

- management of the Group's capital base

- Group liquidity

- Group interest rate risk management, including the funding of non-accrual loans

- Group currency risk management

ALMAC makes recommendations on policy limits to the Board of Directors for asset growth, liability structure, interest rate risk, liquidity and currency risk and reports compliance with those limits on a monthly basis. In turn, it delegates operational responsibility for liquidity, interest rate risk and currency risk management to Group Treasury within certain delegated authorities.

Breaches of policy are reported immediately to the Group Treasurer and Director, Banking, accompanied by explanation and where necessary recommendations as to the action required to remedy the breach." ()

The Asset and Liability Management Committee met again on 19 December 1990. The minutes of that meeting record under the heading "Key Performance Issues and Strategies":

"In anticipation of Board approval of the Committee's new charter the Chairman asked members to consider strategies and key performance indicators for each of the five objectives of the Committee namely balance sheet structure, the capital planning, liquidity management, the interest rate risk management and currency risk management.

It was agreed that ALMAC should focus on the Group's balance sheet structure because that is fundamental to correcting the Group's present difficulties. It was further agreed that fixing the current imbalances in the balance sheet is more important than a short term return to profitability." () [Emphasis Added]

Those minutes provide the clearest evidence of the importance of asset and liability management to the State Bank. They also indicate that it was not until the end of 1990 that the Bank had, at last, acknowledged the requirements of asset and liability management, and taken steps to ensure an overall co-ordination of the task.

A global liquidity policy was eventually approved by the Board on 20 December 1990.()

It was not long before the liquidity information being generated by the Bank was put to use. On 14 January 1991, Ms Kimber, who was then head of ALMAC's Secretariat, made a confidential recommendation that ALMAC endorse steps which had been agreed between the Group Treasurer and the Chairman of ALMAC on 14 December 1990 when "it was decided to arrange for a $1 billion of liquidity to be available to the domestic bank between February to April in order to withstand any pressures in that period". $A 600.0M had been arranged from the off-shore banking unit, and $A 400.0M had been borrowed through the United States Commercial Paper Program. This additional liquidity was sought on the assumption that the Bank's liquidity position, as at 31 January 1991, would be approximately the same as the position, as at 31 October 1990, being the date at which there was available liquidity data. The actions, which had been agreed by the Group Treasurer and the chairman of ALMAC on 14 December, were endorsed by a meeting of the Asset and Liability Management Committee held on 16 January 1991.()

A meeting of the second ALMAC on 16 January 1991 discussed a report from the Group Treasurer regarding a meeting that he and the Director, Banking, had had with the Reserve Bank of Australia to discuss the Group's liquidity. The Group Treasurer also reported that the Reserve Bank had presented results of its own research into the liquidity position of the State Bank which indicated a decline over recent months and a heavy reliance upon short-dated funding. The minutes record that the Director, Banking, reported that the Reserve Bank had expressed concern at the Bank's position.()

Throughout the remainder of the period under review, work continued on the development of the Group Liquidity Reporting Project, and the Global Liquidity Policy was amended to accord with suggestions which had been made by the Reserve Bank on 14 January 1991.

Mr Targett had arrived at the Bank in October 1989. Work on developing a liquidity policy had commenced in January 1990. The evidence shows that his arrival provided the impetus for the steps which were taken.

Despite the serious deficiencies in the way the Bank managed its liquidity up until the end of 1990, there is no evidence to suggest that such deficiencies in liquidity management have directly and of themselves, contributed to identifiable losses that are the subject of this Investigation. What the existence of the deficiencies does, is to confirm that there was no person in the Treasury of the Bank or elsewhere within the Group with a sufficiently broad overview of the asset and liability management function to ensure that the task was carried out correctly until such time as Mr Targett took up his position. Others, such as Ms Meeking, made positive contributions with respect to discrete Treasury functions, some of which, such as the development of the Heaven software, were essential to the introduction of a liquidity policy. There is, no evidence to indicate that any of Mr Targett's predecessors took steps to develop an overall approach to asset and liability management or liquidity management.

It is significant that, from the time when a Group Liquidity Report was first produced in July 1990, Beneficial Finance was demonstrated to be "over-borrowed". Whether that position would have been revealed if Liquidity Reports had been prepared on a Group-wide basis, cannot be decisively demonstrated; the same must be said about the effect that such reports may have had on the course that the Group took. The fact that Beneficial Finance was "over-borrowed" probably means no more than that there were inefficiencies in the way that Beneficial Finance was managing its assets and liabilities which had previously passed unnoticed.

The lack of importance given to liquidity management can, in part, be understood when one has regard to the way in which the Bank developed. When it was established, the Bank had a high proportion of retail funding. At no time did the raising of funds create any difficulty. The high credit rating of the Bank and the Government Guarantee saw to that. When the nature of the Bank's business changed there was a greater reliance upon funds raised in the wholesale market, but the complacent attitude to liquidity management continued. The Bank's funding needs were the responsibility of the Capital Markets section. There is no evidence to suggest that section was other than effective at raising wholesale funds. The Inquiry has been told that the Bank raised funds whenever "windows of opportunity" opened, and that any surplus funds were used to purchase liquid assets which formed part of a "Structured Finance and Risk Management" portfolio.() On other occasions Treasury simply went to the market and raised whatever funds were required to meet a commitment. It is unlikely that such fundraising at short notice would achieve the most appropriate maturities or most cost efficient funding alternatives. Funding in this way may be accomplished quickly and effectively but it diverts focus and resources from more stable deposits as a funding source. The result is a shift of the liability base to a more interest sensitive and more volatile source with progressively greater risk. The problems which arise from funding iliquid assets with liquid liabilities did in fact confront the Bank early in 1991.

On the topic of liquidity management a submission to the Auditor-General by the Bank confirms that:

"Prior to December 1990 there was no formal Bank-wide liquidity policy in existence (other than the Prime Asset Requirement arrangements) and no centralised analysis of the Bank's liquidity position. This situation meant that the Bank was potentially less than fully prepared for a major liquidity crisis". ()

To say that the Bank had no liquidity policy prior to December 1990 at all may be an overstatement; but generally this submission by the Bank accords with the evidence before the Investigation. A draft liquidity policy, prepared by Mr A K Smith dated 13 November 1990, said:

"1. Background

The liquidity position of the Bank has been reported by ALMAC on a monthly basis for the Australian and International Banking Divisions. The policy closely resembles the Bank of England approach, whereby asset and liability cashflows are classified according to a maturity line of schedule ...". ()

A subsequent draft includes the comment:

"... at present, the liquidity position of the Bank is reported to ALMAC on a monthly basis for the Australian and International Banking Divisions". ()

Whether there was a policy or not, the fact remains that Mr Targett and other senior employees of the Bank obviously had serious reservations about the effectiveness of the liquidity policy that was in force prior to the end of 1990.

All the evidence indicates that the fact that the State Bank was so slow in developing a liquidity policy was largely a consequence of the fact that liquidity had never been perceived to be a problem.

The Peats Report, in paragraphs 2.19 and 2.20, had, in September 1989, made what was required crystal clear. The Report said:

"Liquidity Risk Policies

2.19 There are currently no formal policies addressing control over State Bank's liquidity risk. Whilst it is acknowledged that the unique status of a Bank reduces the exposure in this regard, this does not eliminate the need for such risks to be monitored and regulated, particularly for the State Bank's offshore activities.

2.20 We understand that some research into liquidity risk is currently being undertaken and it is recommended that this include the establishment of a formal policy."

Mr Targett says in his statement that the comment in the Peats Report was accurate.() He said:

"In my view, domestic liquidity management was an area in the Bank which was neglected to some extent".

All the other evidence corroborates that statement of Mr Targett.

In my opinion the Bank should not have waited until 1989 to be told that it needed a liquidity policy. Notwithstanding the clear recommendation in the Peat's report, it still took 15 months for a policy to be introduced. In my opinion, a delay of that length, was imprudent and unacceptable.

Regarding the practical affect of the absence of a policy, Mr Targett said the Bank did not have proper information on which it could base decisions as to whether it had an appropriate level of liquidity, and that the available information was very poor. Specifically he said:

"We had to know what the Bank asset and liability profile was, so that we could make decisions about how it will access the funding markets in terms of matching the Bank's assets and liabilities. Decisions were made to close off some gaps, but without the basic information it was very hard to make the right decisions".()

Dealing with the circumstances that made it important for the Bank to introduce a liquidity policy during 1990 Mr Targett said:

"The offshore capital markets were becoming less liquid and therefore the committed funds which the State Bank were seeking to access were being priced far more expensively. There would have been a substantial price to pay if we had borrowed some more committed money at this time. Accordingly, we were forced into the short term market. Yet, the Bank's balance sheet was continuing to grow. The alarm bells were ringing because of these issues and precipitated a change and emphasis only shortly after the draft policy came into existence." ()

The evidence is clear that, until 1990, liquidity of the Bank was completely unmanaged, and the Bank relied upon its credit rating and the Government Guarantee. The requirements of the Reserve Bank's Prudential Statements were not satisfied. Contrary to paragraph 12 of Prudential Statement DS1, the Bank assumed that the behaviour of depositors and borrowers was predictable, and that the Bank would always be able to fund any iliquidity shortfall by purchased money.

The evidence as a whole indicates that because liquidity management was not carried out in an appropriate fashion, proper attention was not given to the imbalance which was developing between liquidity on the liability side of the balance sheet, and liquidity on the asset side. That imbalance was allowed to grow unchecked, as reliance on short term borrowings from wholesale sources increased.

The evidence leads me to the conclusion that if an appropriate liquidity policy had been in force, and reports had been prepared which highlighted the growing imbalance, the dangers associated with allowing continued growth in the Bank's assets would have been highlighted, and the subsequent decline in the Bank's financial fortunes would have been greatly mitigated.

7.5.8 RATE RELATED RISKS

The nature of a bank's business, involves risks arising from movements in interest rates and rates of exchange for foreign currency. The fluctuations produce either a profit or loss to the Bank, depending on the nature of the movement. There are ways in which such movements can be managed to maximise a bank's profitability. The management of these risks is normally, and, in the case of the State Bank, has at all times been, the responsibility of the Bank's Treasury.

Mr Targett said that, when he relieved Ms Meeking in December 1988 and January 1989, he formed the view that the swap trading() and the foreign exchange trading was less than satisfactory. So far as the swap and derivative portfolio was concerned, Mr Targett said:

"(The Bank) had a book that went out to 10 years and beyond of swaps and other instruments and it was not ... marked to market properly, so it potentially had losses on the books, and the people running it did not really, to my way of thinking, did not really have a sense a focus in terms of how they were trying to structure that book or what they were trying to achieve. They did not have any proper measurement systems, any proper reporting systems, and from that point of view I just had concerns intuitively that there was some problems there." ()

So far as the foreign exchange trading was concerned, Mr Targett said:

"... there was substantial volatility in the earnings from that business, and there was no real customer base in foreign exchange. So it was really a traditional, almost speculative activity that ... at times produced good results and at times did not but ... the bank shareholder over time would have been a little concerned about the sort of volatility that was coming in the earnings ...". ()

Mr Targett said speculative trading took place. He was less concerned about the foreign exchange trading than the swap activity. He said:

"With Foreign exchange you can stop the business and let the cash flows run off. It is only a very short-term book, and it is very easy to see your profit and loss. But with the swap book, because of the improper measure of risk and the fact that it did not have a mark to market at that time, the fact that the Bank held a lot of illiquid stocks and so on, I was a little more concerned that we could take a fair bit of risk in that book without identifying it and knowing about it, and that was the one that was probably giving me more concerns ....". ()

Mr Targett said that Ms Meeking recognised the problem in foreign exchange, but she did not recognise the problems in the swaps area to the same extent that he did. Mr Targett felt that the limit structure could have been a little bit tighter and improved upon, but he did not feel that the limits were unacceptable.()

Ms Meeking acknowledged that the foreign exchange activities of the Bank, in late 1988 and 1989, left something to be desired. She has told the Inquiry that, in late 1989, she attempted to recruit a person who had won an award as the best foreign exchange dealer in Australia, but her actions were thwarted when Mr Clark agreed with that person's current employer to withdraw Ms Meeking's offer of employment.() She recognised that a major change was needed in the area, and she put "a major restructuring proposal " to Mr Mallett, which was discussed with Mr Targett in London; that Mr Targett requested that no changes be made prior to his expected arrival in Australia later that year. Ms Meeking says that Mr Targett's request was given effect to, with the consequence that she was "ostensibly responsible for this area which continued its lack lustre performance for the next six months."()

There is evidence of a lack of expertise amongst the Bank personnel who were engaged in this segment of the Bank's business. There is, also, evidence that the Bank actually suffered losses on its trading. There is, however, nothing to suggest that those losses were any different from the trading losses which are likely to be suffered by other similar organisations and there is nothing to suggest that those losses have any relevance to the matters which are the subject of this Report.

Accordingly, this Investigation has not embarked on an analysis of the trading activities of the Bank. At most, the evidence of Mr Targett on this topic does no more than to confirm other evidence that there was a general lack of expertise in the operating sections of the Bank's Treasury.

7.5.9 THE LONDON TREASURY

This Report has been concerned primarily with the operations of the Treasury in Adelaide, because that is where the overall management of the Bank's assets and liabilities should have taken place. I have not sought to examine in detail the operations of the overseas treasuries. There is, however, one aspect of the treasury operations in London that is relevant to the Investigation.

The operation of the London Treasury is described in the statement of Mr Targett, who was the Treasurer, London, from March 1988 until October 1989. He said:

"The main role of the London Treasury was to fund its asset book. That is, raising the wholesale funding for those assets. It was also involved in limited spot and forward foreign exchange trading and a small level of securities and synthetics trading."()

Mr Targett also said that when he joined the Bank:

"The Bank's London Treasury Division was not functioning well and was losing money. The Bank, being a small South Australian financial institution, didn't have a competitive advantage in the market place. It was trying to concentrate on trading Australian dollar products in the London market. However, without good traders and direction, it was, in effect, simply providing liquidity to the market rather generating any real business. There was no underlying customer base. It was also my assessment from previous experience that the operation was badly managed and badly focussed." ()

The chain of command in the Treasury in London was that the Treasurer reported to the Chief Manager of the London Office, who in turn reported to Mr Mallett. The Treasurer was responsible for five staff in the London office.

Mr Copley visited London for purposes which were not related to the matters which are the subject of this Chapter in May of 1989 and June of 1990. At the time of his second visit he met, privately, with the external auditor of the London office. The auditor told him that he had previously had a clash with a person who had just been appointed to a position with the Bank in London. The matter was of sufficient concern to Mr Copley to raise it with Mr Clark and Mr Mallett on his return. It caused Mr Copley to become concerned about the difficulty of controlling an operation that was 12,000 miles away.()

Mr Targett described the course taken by the London Treasury after he returned to Adelaide in the following way:

"When I joined London Treasury in 1988 it was involved in funding the local asset book and trading on short term money markets with liquidity and low risk. After I returned to Australia, the London Treasury became involved in more speculative trading with large risks and eventually losses. It gave a liberal interpretation to the limits which were in place. The former Treasurer, Warwick Salvage, did not formally report to Lyn Todd on a regular basis.

London began trading in markets involving risks outside of 12 months. It was taking an outright risk to maybe 10 years. In my opinion the limits that were in place only covered risks in the short term markets. The limits that were advised to them did not go into much detail and they took advantage of a liberal interpretation of their risk parameters.

I thought the risk was large because as a small South Australian Bank in London and the real role that you have is to enhance the return of your natural business. The risk versus the reward equation did not stack up. ... because of the risk they were taking in the long end they were going to get more volatility and potentially greater loss or greater profit." ()

Mr Copley's fears were realised. In August of 1990, the London Treasury lost about GBP 0.5M. As a consequence of the loss, a report, dated 9 October 1990, was prepared for Mr Clark by KPMG Peat Marwick McLintock.

The report attributed GBP 0.307M of the loss to a series of three "spread" positions in Euro-dollar futures, which had been taken by a dealer in the Treasury. The remainder of the loss was attributed to a GBP 20.0M five year sterling interest rate swap which was transacted by the head of the Treasury, on Thursday 2 August 1990, after the invasion of Kuwait earlier that morning.

KPMG Peat Marwick McLintock had been told that the losses were primarily attributable to what was referred to as a "butterfly" spread position opened prior to the invasion of Kuwait. Their investigation revealed that that was not the case and that the loss was to be apportioned as follows:

(a) GBP 29,000 to the "butterfly" spread position opened prior to the invasion of Kuwait;

(b) GBP 0.166M as a consequence of a "boomerang" spread position opened prior to the invasion; and

(c) GBP 0.112M as a consequence of a "boomerang" spread position opened on the day after the invasion of Kuwait.

Spread trading is dealing in interest rate futures by buying one part of a yield curve and selling another part in the expectation that the shape of the yield curve will move in the dealer's favour. The "spread" is the difference between the price of futures contracts for different contract periods. A detailed analysis of the complexities of spread trading is beyond the scope of this Report.

The significance of the "spread" trading referred to in the report of KPMG Peat Marwick McLintock is that it demonstrates that the London Treasury was engaging in trading for the sake of trading, rather than trading as something ancillary to the core activities of the branch.

KPMG Peat Marwick McLintock concluded that none of the spread positions which gave rise to the loss had breached limits set by the Bank, for the simple reason there were no specific position limits for spread trading.

The report of KPMG Peat Marwick McLintock observed:

"... the nature of the treasury operation and the current size of interest rate limits means that future losses on the scale experienced in August are far from inconceivable. It would appear that the management of SBSA in Adelaide are insufficiently aware of the potential of the London treasury to make losses as well as profits.

We recommend that London and Adelaide immediately discuss and agree upon a clearly defined limit for interest rate risk, and that daily reporting of exposures against this limit arising from off balance sheet positions is instituted using the Devon system." [Emphasis Added]

The report made the following observations about the nature of London Treasury operations at the time the loss was incurred:

"The spread trading described in the previous section is not typical of the overall business of the London treasury ... Since ... 1989, the Treasury has been an aggressive and successful risk taker, highly focussed on US$ and Sterling interest rate risk. This has been developed to complement the successful and relatively low risk FRA arbitrage activity. The concentrated nature of the risk may have been partially obscured by the fact that certain major positions have related to funding provided by Head Office, and significant profits have been made from timing differences between "borrowing" from Adelaide and "lending" to the London market. These profits have been recognised on an accruals basis. However, it is the policy ... to "hedge" or "match-fund" the branch balance sheet and to take significant discrete and easily identifiable positions only in off balance sheet instruments for two reasons:-

. Existing systems do not provide adequate information on which to manage interest rate gaps. However, the new Devon system gives much better control over positions in off balance sheet instruments,

. (the person concerned) prefers the freedom afforded by off balance sheet instruments to take positions according to his market "view" without having to tailor this to the more limited opportunities naturally provided by the management of the branch balance sheet.

The style of the treasury operation, together with the concentration on two narrow categories of risk, imply that over time both profits and losses are likely to be significant ..."

In a section of the report which discussed the interest rate limits in the London branch, the comment was made that:

"It is clear that those directly responsible for the management of the Treasury operation do not share a common understanding of the total permitted quantum of interest rate risk. This is exacerbated by the adoption of an interest rate gap limit to a purpose for which it was not intended, that is control of interest rate risk arising from mark to market positions in off balance sheet instruments."

The report of KPMG Peat Marwick McLintock found that the circumstances surrounding the losses in early August 1990 revealed inadequacies in management information. Those inadequacies are discussed in detail in the report. There was a recommendation that a more wide ranging study of the London Treasury operation should be conducted. It was suggested that there was an urgent need for action in connection with "the understanding and management of interest rate risk arising out of the off balance sheet activities of treasury in London".

As a consequence of these losses, spread trading ceased, and the trading activities of the London Treasury were curtailed. The activities reverted to the funding of the local corporate asset book.

Mr Targett gave evidence that there was no reason to have a treasury in London apart from the fact that the Bank had a presence there, and that it had a portfolio of assets that needed to be managed. His view was that, if the Bank was to have any speculative activities in London, they should have been confined to the very short and liquid end of the market, so that if anything went wrong, the Bank could identify the problem, and quickly extricate itself.

Mr Targett said that, after he left the London Treasury, it became involved in a lot of illiquid and longer term risks. He said "I thought that probably the change in focus was inappropriate and they clearly became more speculative to try and boost earnings quicker." () He said it was really not the sort of thing that a State bank in London should have been involved in because "there (was) no reason for a State bank to have a presence in London, apart from its asset book so you only need to maintain a modest profile." ()

On the evidence before me, I accept Mr Targett's evidence that there was no justification for the trading which was engaged in by the London Treasury, apart from what was necessary to fund the local asset book. By and large, the trading was highly speculative.

KPMG Peat Marwick McLintock pointed out that no position limits had been breached, because such limits did not exist. The Bank's failure to establish and enforce appropriate limits was the very circumstance which allowed the losses to be incurred.

The report of KPMG Peat Marwick McLintock also indicated that the problems were exacerbated by the lack of understanding by the Head Office in Adelaide as to the nature of the activities that the London Treasury was involved in. That lack of understanding, and the problems of communication associated with controlling a business on the other side of the world are illustrated by the evidence of Mr Mallett. He said:

"... in late 1990 when the Chairman of the Board went to London and got extremely upset because London told them they still did certain foreign exchange transactions, and said he never knew that London was involved in foreign exchange and yet he had been actively approving foreign exchange trading limits for London for the past seven years." ()

Mr Simmons strongly disputes the evidence of Mr Mallett. First, he denies ever uttering the words to Mr Mallett.() Secondly, he says that he was well aware of the fact that the Bank had been engaging in foreign exchange business in London.()

Mr Simmons said that, in 1987 and 1988, the Bank had made foreign exchange losses in London because the Bank was taking unhedged positions in the Australian Dollar which at that time was a speculative currency and being widely traded. On his return from a trip to London, Mr Simmons raised the matter and he understood that instructions were given that the foreign exchange dealings in Australian Dollars were either to be brought to an end, or not to be taken without the position being hedged. He said the London operations were generally not profitable.()

Mr Simmons gave evidence that, in October 1990, he went to London and was told that there had been a loss of GBP 0.5M. He said:

"The Board hadn't been told about that loss, and it was being brought to account on a monthly or quarterly basis, so it was in effect hidden from the Board. I went to see Robert Rhys, who was the Partner in charge of the audit for the Bank at Peat Marwick, and he had prepared a Treasury report of the London Branch operations. That report was quite scathing about some of the systems in place. I had to tell Rhys that I demanded a copy of that report as Chairman of the Bank. This report had been prepared at the request of Mr Clark. On going through that report I was concerned, and there was a presentation for me as Chairman of the Bank from the various heads of the London Branch ... so I was not at all happy with the whole of the London operations and in particular the Treasury operations."()

Mr Simmons said that he thought that the dealer was taking unprotected positions, and that he was getting to the stage of punting, which Mr Simmons regarded as a dangerous course.

I accept this evidence of Mr Simmons. It does establish that Mr Simmons was aware of the foreign exchange transactions in the London Treasury prior to late 1990. More importantly, however, it shows that, not only was the Board handicapped by the distance which separated the London operation from the head office, but that the Directors were not kept informed in the way that they should have been. Because this evidence only came to light at a late stage of the Investigation it has not been possible to pursue the question of whether the fact that the Directors were not informed was deliberate or inadvertent. Because this matter has not been pursued I draw no adverse inference against any person.

When he was asked to comment on the KPMG Peat Marwick McLintock Report with respect to the losses in London, Mr Targett said:

"That the types of trading were really inappropriate and we probably needed to look at the way that business was organised and more particularly the fact that no-one seemed to be on top of the risk that it was running. It was reporting to a local manager and we just lost track of the kind of risk we were running in that business." ()

He also said that the trading limits which applied were inappropriate for the sort of business profile that had developed.()

The evidence suggests that, because of the lack of attention given to the London Treasury by the persons who should have been monitoring and directing its activities, London Treasury had, by default, carte blanche to do as it pleased. The Board of Directors, the Managing Director and Mr Mallett, as Chief Manager Treasury and International, should have paid much closer attention to the activities of the London branch and its Treasury, particularly having regard to the comment of KPMG that "over time both profits and losses are likely to be significant".

The Bank has submitted that it is appropriate to maintain a Treasury operation in London to manage aspects of the Bank's off-shore funding programmes and associated hedging programmes. The Bank does not share the views expressed by Mr Targett on the absence of reasons to have a Treasury in London.()

On the basis of Mr Targett's evidence and the material in the report of KPMG Peat Marwick McLintock, I have concluded that if there was any justification for the existence of a Treasury operation in London, there was no justification for the existence of a fully autonomous Treasury operation which engaged in speculative trading in a way that was not subject to appropriate limits, and was neither understood nor approved by the Head Office, in particular, the Board of Directors.

7.5.10 THE STAFFING OF TREASURY

As the Bank grew, so did the volume and sophistication of the Treasury activities.

Notwithstanding the relatively simple demands that were placed upon the Treasury at the time when the Bank commenced its operation, I have come to the conclusion that the Treasury was not appropriately staffed for the majority of the period between 1984 and late 1990.

Many witnesses have made the observation that the location of the Bank in Adelaide made it difficult to recruit staff with appropriate treasury experience. In addition, there was initially a policy of limiting recruitment to within the Bank.

With few exceptions, the staff in Treasury, in particular, those who from time to time were in charge of Treasury Operations, had no training or experience in an operation of the type that the Bank was to become. That does not mean that they were incompetent or without ability in other areas, but it did result in a situation where there was nobody in the Treasury who had a complete understanding of the systems and procedures that were required to meet the needs of the growing Bank.

Mr Ottaway was effectively required to do no more than continue the Treasury Operations of the two predecessor banks. He had had a distinguished career with the old State Bank. Nevertheless, the evidence which he gave to the Royal Commission about his appointment as Chief Manager Finance was:

"It was the one job that I could have been given but I didn't actually have the experience for." ()

Mr Hazel was recruited because of the perception that he had experience in Treasury Operations. Indeed, Mr Hazel did have experience in treasury operations and he was well qualified in many respects. As Mr Paddison has observed, however, Mr Hazel's strengths were as a dealer, not a manager, and because of that he was not a completely appropriate person to plan and put in place a Treasury of the type that was going to be needed by the State Bank.

Mr Hazel was succeeded by Mr Mallett. Mr Mallett was widely experienced in different areas but he had no experience in treasury. When he was appointed, he already had a full time position as Chief Manager International. In fact, Mr Hazel objected to Mr Clark about Mr Mallett's proposed appointment.()

Ms Meeking was appointed as Senior Manager, Treasury and International reporting to Mr Mallett. She did have practical experience in treasury operations and that experience was of undoubted benefit to the Bank. Ms Meeking, however, did not have the experience which was necessary to assume an overview of the asset and liability management of the Bank.

Mr Mallett's perception of the level of experience within Treasury staff is illustrated by his evidence:

"I recognised there was a need to improve some of the discipline skills in Treasury and that was when I seconded Steve Targett from London Treasury to Adelaide Treasury. I think that was in the latter part of 88."

He also said:

"It was extremely difficult in a changing market, with home grown staff in the whole Bank to keep everyone up to speed ... It created risks of its own but you had to bring in people who again had the experience you wanted in other markets with other employers.

And working in Adelaide ... we are the only bank in Adelaide ... This is not a financial market. We did have difficulty, frustrated by all sorts of reasons to bring in experienced personnel, particularly in the more esoteric areas of the Bank's activities." () [Emphasis Added]

When Mr Paddison was appointed to the position of Chief General Manager, Australian Banking, he became ultimately responsible for the newly created Australian Treasury. Mr Targett was appointed, at Mr Paddison's request, to head the Treasury function for the Australian domestic Treasury. At the time of his appointment Mr Paddison had no experience or training that qualified him for appointment to the position as treasurer of a bank of the type that the State Bank had by then become. The evidence suggests that, during 1990, probably with the assistance of Mr Targett, Mr Paddison did begin to develop an understanding of what was required.

Mr Mallett's views about the handicap that the Bank suffered in recruiting experienced personnel as a consequence of the Bank's location in Adelaide is shared by Mr Targett. He said that even before he joined the State Bank, he was "very aware that the skills within State Bank of South Australia were just below standard". He also said "it was no fault of the people. It was just simply that ... sitting in Adelaide ... they just were not ... able to attract the right sort of skilled people that the marketplace would demand and we were trying to run an aggressive treasury and match the bigger players, I guess, without the tools to be able to do it." () [Emphasis Added]

Nobody has criticised the appropriateness of Mr Targett's appointment. On all the evidence, I am compelled to find that, with the exception of Ms Meeking (whose area of responsibility was restricted), Mr Targett was the first person in charge of the Bank's Treasury operations who was appropriately qualified for the task.

The evidence is that the staff who worked in Treasury under those whom I have specifically mentioned were, in general, inappropriately qualified to meet the growing requirements of the State Bank. It was because of the lack of expertise in the Adelaide office that the separate dealing operation was established in Sydney. The evidence before me suggests that the Sydney operation has been nothing but successful.

Without being unnecessarily critical of persons who have served the Bank diligently and with dedication, I am compelled to conclude that for almost the entire period under review the Bank's treasury operation lacked sufficient expertise within its staff. The Treasury staff were required to carry out a task which was beyond their experience.

7.5.11 THE PROLIFERATION OF TREASURY OPERATIONS

Reference has already been made to the fact that there were separate treasuries in Adelaide, London, New York, Auckland, and Beneficial Finance. In addition, the Adelaide Treasury was, for a time, divided into Australian and International Treasuries. Each treasury acted independently, and there was no co-ordination of their activities.

The loss suffered by the London Treasury in August 1990 is clear evidence of the risks that the group was running. In addition, there is evidence that the lack of co-ordination gave rise to an inability to co-ordinate off-setting positions.

There is also evidence (previously mentioned) that the Treasuries of the Bank and Beneficial were actually competing against each other in the market.

The potential for confusion was exacerbated by the different reporting lines. There was no person who was able to take an overview of all the Treasury Operations of the Group.

Mr Targett now considers the splitting of the Adelaide Treasury into International and Australian Treasuries to have been an inappropriate decision. That conclusion can also be inferred from the subsequent decision to consolidate the two treasuries.() Mr Targett said:

"... It causes two problems. One is the sort of division with people working for their own means rather than as a group. That particularly impacts on the way the Bank funds itself and gets organised for any sort of global funding, and those sorts of things. The other problem that comes from that is that there is inconsistent risk policies and practices across

Treasury and that probably is inappropriate I think from the point of view of probably the Board of Directors and the Executive Committee. So ... we were too fragmented." ()

Mr Targett said the Treasury Operations were fragmented, in that "in terms of coming up to the top of the Bank it came through two executives rather than one ...". ()

The establishment of a separate treasury in Sydney contradicts the principle that the treasury operations should be consolidated. Mr Targett was responsible for the establishment of that Treasury. His reasons were that the swap portfolio was not being properly managed. He said his first priority was to get some real expertise in to manage that, but while he would have preferred to manage it out of Adelaide, the financial markets were in Sydney, and the type of people the Bank wanted were in Sydney. He also said that, in the longer term, it probably made sense for the Bank to have a presence in Sydney in the form of a Treasury, because of the problems which had been previously experienced in recruiting appropriate staff in Adelaide.() All the evidence is that the Sydney Treasury has been highly profitable.()

A difference between the Sydney Treasury and the treasuries which developed overseas is that the Sydney Treasury has, at all times, been managed by the Group Treasurer in Adelaide, and its activities have been co-ordinated with the general activities of the Group and the Bank, whereas the treasuries developed overseas were autonomous and there was no co-ordination of their activities.

In his statement(), Mr Targett observed that the Australian and overseas Treasury offices were totally autonomous, and that common procedures were not implemented in the offices due to differing management approaches. When asked who should have been sufficiently aware of that situation to identify what was happening and to take immediate action, he suggested that it should have been the person to whom Mr Paddison and Mr Mallett reported, namely the Managing Director. So far as the Board of Directors was concerned, the evidence of Mr Targett, with respect to their role, was:

"I think that the Board need to know the policy framework and risk parameters that surround any business and treasury is no exception. I think that they perhaps should have had a better handle on treasury risks that were taken globally and - the types of business that we were engaging in. But certainly the Managing Director also, I think, had a very strong role to play because of the business was split in two." ()

The only persons in a position to co-ordinate the activities of the various treasuries were, in practical terms, the executives or groups which stood above the persons who headed the treasuries. For most of the period, the executives who headed the treasuries were Mr Mallett and Mr Paddison. The only persons or groups who stood above Mr Mallett and Mr Paddison, and who had the authority to co-ordinate the different Treasury activities of the Group were the Managing Director, the Executive Committee, and the Board.

In all the circumstances I have concluded that the Managing Director, the Executive Committee, and the Board, were in breach of their duty in failing to ensure that the Treasury Operations of the Group were properly co-ordinated and managed.

In a submission to the Inquiry, the Bank has said that it is in agreement that not all Group Treasuries have been justified and that it agrees that all Treasuries should have been co-ordinated. The Bank does not, however, agree with the assertion that all Treasuries have operated independently and with no co-ordination. It says that there has been very deliberate co-ordination of off-shore Treasuries, virtually from inception, particularly with regard to capital market activities, that limit co-ordination has been in place, and staff have been exchanged. The Bank said there was a need for total co-ordination and that occurred with the total centralisation of Treasury management. The Bank contends it would be an unjust criticism to imply that, prior to the total centralisation of Treasury management, each Treasury acted totally autonomously.()

Because of the comparatively late stage of the Investigation at which the submission was received it has not been possible to corroborate the factual assertions contained in the Bank's submission. The Inquiry has not seen evidence of co-ordination of Treasury activities, but that does not mean that some co-ordination did not occur. Otherwise the Bank's submission does not cause me to revise any of my findings with respect to this section of the Report.

7.5.12 THE RESPONSIBILITY FOR OVERALL ASSET AND LIABILITY MANAGEMENT

Mr Targett said that the overall purpose of the asset and liability management of a bank should be three-fold. He said:

"I guess the first thing that is important is to make sure that the Bank has got the right sort of liquidity guidelines and controls in place just to make sure the Bank is able to meet its obligations because if you have a liquidity crisis that will kill you before anything else, so I think that is function number 1.

... Function number 2 is that in terms of the way the Bank is funded and it is mixed between short-term and long term funding, on-shore and off-shore funding and also from the point of view of looking at the group rather than the Bank, I think it is important to set up some policies and guidelines in that area so that there is an element of structure and an element of organisation in the way you set up the liability side of the balance sheet.

The third one, ... is to make sure that your assets and liabilities are structured in such a way that you either depending on what your objective is, whether you want a smoother profitability coming from that area or potentially increase it, that the book is structured in such a way that you either make sure that you do not lose movements in interest rates or you gain by structuring it in such a way that it suits your view of the market.

So I suppose in those three areas, liquidity, funding and also just in terms of the way you want to structure the Bank's book from the asset and liability profile to either neutralise it or to profit, ...". ()

There is some evidence that the first ALMAC did, initially, have a limited responsibility for the overall management of the Bank's assets and liabilities.() There is also evidence to the contrary. In any event, the first ALMAC was dissolved.

Whether the first ALMAC did, or did not, have initial responsibility for the overall asset and liability management of the Bank, the evidence is that little, if anything, was done to carry out that function. Also, as the first ALMAC turned into a pricing committee, the perceived importance of the need to carry out asset and liability management in the Bank diminished.

There is no evidence that the need to manage the assets and liabilities on a group-wide basis received any consideration until 1990.

As I have mentioned already, Mr Ottaway gave evidence that he was unable to clearly recall whether he had, in 1984, been responsible for the asset and liability management function of the Bank, but said he assumed that, as Chief Manager, Finance, he did. He added that it was the first ALMAC that had responsibility for the way that the asset and liability management function was carried out, but that no member of the first ALMAC had real experience in the area of asset and liability management.()

Mr Hazel agreed that the overall management of assets and liabilities is an essential function. He never perceived that he, as the head of the Treasury had responsibility for that function. He testified that up until the time that he left the Bank to go to Ayers Finniss, the function did not receive the attention that it should have.()

There is conflicting evidence about who assumed responsibility for asset and liability management upon the dissolution of the first ALMAC. Mr Clark says that the Finance department, in particular, Mr Copley, inherited that function. Mr Copley denies that.

Mr Copley testified that he was appointed Chief Manager, Finance and Planning, at about the time the first ALMAC was dissolved. He was never a member of that committee. He said it became his responsibility to manage the structure of the balance sheet from the point of view of its presentation for accounting purposes. Mr Copley asserted that it was the responsibility of each discrete business unit to manage their own assets and liabilities, and that there was:

"... confusion in the minds of people as to what was the role of asset and liability management, and what was the role of the discrete business unit. And they were writing their own business and there were no real checks being made as to where - what part of business was being written."

Mr Copley said that there was nobody at that time who could take responsibility for an overview of the Bank's assets and liabilities.()

Prior to his appointment to the Bank, Mr Copley had been a senior finance executive with a large public company which was unconnected with the business of banking. He had had no experience in the asset and liability management or treasury operations of a bank. If Mr Clark is correct in saying that, on the abolition of the first ALMAC, Mr Copley was appointed to take an overview of the Bank's asset and liability management, then, notwithstanding the expertise Mr Copley undoubtedly had in other areas, the decision to transfer the overall responsibility for the function from an asset and liability management committee to a person with no relevant experience is itself evidence of a lack of understanding of the requirements, and the importance, of the task.

Also, if Mr Clark is correct in saying that Mr Copley was given the responsibility, Mr Copley did not appreciate that fact and he did nothing to perform the function. Such a situation would be incredible.

In addition, Mr Copley says that he was never advised that the responsibility was his.() There is no direct evidence that such advice was given to Mr Copley, but the Executive Committee minutes, which are referred to above, do imply that Mr Copley's appointment was, in some way, associated with the management of responsibility for this matter.

Mr Clark has disputed Mr Copley's denial of the fact that he inherited the ALMAC functions from the Finance department. He has said that, when the first ALMAC was dissolved, it was very clearly understood that one of the reasons why the Bank was able to dissolve the ALMAC was that pricing would be the function of the individual line managers, and Mr Copley, as head of Finance, would be responsible for overall management of assets and liabilities within the Group. He said it was for that reason that Mr Copley was designated Chief Manager, Finance and Planning, and he denies that Mr Copley did not appreciate his function.()

There is no evidence that the Board, the Executive Committee or the Managing Director showed any interest in the way that Mr Copley carried out the task of asset and liability management. There is no evidence that he was reprimanded for not carrying out what is said to have been an important part of his duties. These facts warrant an inference - which I draw - that Mr Copley had not been made responsible for the ALM function. Mr Copley had no experience in the management of the assets and liabilities of an organisation such as the State Bank. If Mr Copley had been made responsible for the ALM function without the full extent of his responsibility being explained to him, and with no support being made available to help him to understand the requirements of the task, that, in my opinion, was not significantly different from leaving the function unattended.

Mr Mallett assumed control of the Treasury at about the time the first ALMAC was dissolved. He gave evidence that up until the time of the establishment of the second ALMAC, he "was not aware of any major exercise that co-ordinated the Bank's balance sheet as a whole".() He said:

"I wasn't aware of someone who sat on top of the different areas and basically said: if you are projecting that level of asset growth how is it going to be funded? I was not aware of that at all." ()

Mr Mallett said that the focus of the second ALMAC, at the time of its establishment, was "on interest rate risk management, present value of future cash flows." When asked who had performed that task prior to the formation of the second ALMAC he said:

"... the only trading that was done was that Treasury managed its interest rate risk within its lending limits, and that was it. There was no understanding of the Bank's interest rate position in other areas the risk it ran through mismatched interest rates at that time." ()

He also said that when the second ALMAC was formed, it was the first time that the balance sheet as a whole came under a more formal sense of understanding or identification in terms of interest rate management. ()

Mr Mallett said that in its early stages the second ALMAC was not concerned with the management of the Bank's balance sheet. He said:

"... it was obviously a learning process. It (ALMAC) was there and it had to crawl before it could walk, and it was building up the skills that it needed. Coupled with that, of course, at that stage we would have had no idea. We didn't have the system that pulled together the Bank's total balance sheet other than manually." ()

Mr Targett agreed with the suggestion that, for a time, the State Bank really ignored the broader function of asset and liability management. He said:

"When I first sat on the Asset and Liability Management Committee when I came back it really took me quite a time to understand just exactly what the function of that committee was and what its objectives were ... Quite clearly asset and liability management function was one where as a Bank we just did not do it well enough. I mean, there were people there that were trying to do the right things but I think that no-one really sat back and really drew a charter and set up the parameters for what it was meant to be achieving and how it was going to be structured." ()

Speaking of the time when he became Chief Manager, Mr Targett said:

"... We did not even have data ... at that time which showed us the profile of the book in any meaningful way and certainly we did not have any information that had the whole group covered. ... We tended to address peripheral issues in those meetings for quite a time rather than the fundamental type things and so I would say it was probably ignored. ...". ()

In is view, overall responsibility for asset and liability management rested with the Group Managing Director; but the Managing Director did not involve himself in that activity in any way.()

He also said that the Board of Directors did not provide any initiatives in the area of asset and liability management.() He said that when he was on the second ALMAC he "did not see any sort of directives really coming from the Board, it was more what the Asset and Liability Management Committee would tell the Board rather than any sort of directives coming the other way." ()

Mr Targett summarised his perception of the situation thus:

"One of the things that was concerning me was that the Bank really did not understand its cash flows well enough. It was almost like(the Bank) was managing this big bucket of funds where money was going in and out but in terms of properly measuring the cost of capital and how it was allocated and all those types of things which also fits into the asset and liability side, there was not any sort of policies in that area, so it just was not happening well enough." ()

The Peats Report highlighted the need to clarify the respective roles of Global Risk Management, the Asset and Liability Management Committee, and individual business units. Mr Targett agreed. When asked to comment on the observation that there was really nobody standing above the whole process, giving a clear direction on asset and liability management, Mr Targett said:

"Yes, that is very true. Not only asset and liability management, also the sort of risk policies that were the framework around the business overall. ..." ()

Mr Targett gave evidence that that recommendation in the Peats Report was never to any extent taken up during his time with the Bank in any definitive way. He thought that the responsibility for defining that roles of the respective committees rested with the Chief Executive and the Executive Committee, who should have informed the Board how the Bank was organised.()

The overwhelming weight of the evidence is that, until about the beginning of 1990, no proper attention was given to the need to manage the assets and liabilities of the Bank and, equally important, the Group in an overall sense.

The solicitors for Mr Clark have submitted that Treasury operations were not his area of expertise, and that he was entitled to rely upon the experts whom he had appointed. They submit that no Chief Executive can be expected to have expertise in all areas, and that he believed, on reasonable grounds, that he had done all within his power to bring professional expertise to the area.() There is some force in the submission that the Chief Executive of a business such as the State Bank can not be expected to be a master of all the complex areas of the Bank's business. The evidence does not, however, support the submission that Mr Clark had reasonable grounds to believe that the asset and liability management was being carried out. He may not have been conscious of the difficulties; but that may have been a consequence of a combination of his own lack of expertise and his failure to concern himself more in that aspect of the Bank's business. In my opinion, Mr Clark should have taken a greater interest, and paid more attention to the asset and liability management of the Group.

In any case, one may concede that Mr Clark could not have been expected to be master of all esoteric areas of the Bank's business, and, at the same time assert - as I do - that, as Chief Executive Officer, he should have known, or come to recognise, how important the function of managing assets and liabilities within the Bank was, and should have satisfied himself that the function was well and truly performed - by, of course, someone with the necessary esoteric knowledge and skill.

In short I am driven to the conclusion that the Managing Director and the Board failed in their duty. Although, of course they cannot be expected to have carried out the asset and liability management, themselves, they should have ensured that this important function was being attended to, and that appropriate systems and procedures were in place well before the steps that were taken during 1990.

7.5.13 THE SYSTEMS USED IN TREASURY AND FOR ASSET AND LIABILITY MANAGEMENT

Mr Clark gave evidence that the development of procedures and systems was left behind by the growth that occurred.() Mr Hazel confirmed that. He said:

"With the benefit of hindsight I think the growth of the Bank that occurred ... from that period would mean to me that we should have taken a much earlier and more aggressive approach to systems development than we did ... It did not grow in terms of systems development as it should have." ()

So far as the requirements of treasury and of asset and liability management were concerned Mr Paddison said that, because there were a lot of different systems, there was a difficultly in putting together the information that was necessary to take an overview. The reason for that was that many of the systems were developed specifically for the particular business units and most of them were based functionally around lending.() He said the disparate systems gave rise to practical problems in that it was difficult to get good, reliable, timely data.() Although there was an Information Systems division, that division was unable to co-ordinate the different systems in the Bank because of the growth and divisional autonomy.()

In Treasury, different systems were introduced as the operation grew. The Kapiti system was introduced to handle the foreign currency dealings of Treasury. In 1990 the Sendero and Chase software packages were introduced to manage interest rate risk. The Heaven software system was an initiative of Ms Meeking and its development was perfected by her successors. Moreover, there were different systems in different treasuries. Kapiti was used in New York and London. A system called Midas was used in New Zealand. Beneficial used a system called FRS, and in the Australian Bank there was a system called Hogan. Mr Paddison said "you had virtually almost a completely separate system in every location and even some of the lending systems did not generate a good funding interest rate risk rate capacity." () He gave evidence about problems with the ALMAC software.()

Mr Mallett said that the development of systems was an ongoing issue and that "systems continuously needed improvement, will always need improvement." ()

Mr Targett agreed with the comment, on paragraph 5.5 of the Peats Report, that the systems in use, as at September 1989, failed to adequately fulfil the State Bank's needs. He said:

"that in areas other than foreign exchange namely swaps and risk management, clearly we did not have a handle on what the risk looked like so the Kapiti system was just inappropriate for where the business had been taken to".

He said there was no business plan for Treasury.() He also said:

"... there was no definition from the top as to what our system strategy should be or MIS strategy should be. You tended to develop your own, because it was the only way you could be comfortable with your own business unit." ()

A detailed analysis of each of the systems, and their suitability for use in the Bank and in the Treasury, in particular would be a very time consuming and, so far as this Investigation is concerned, unnecessary task. The uncontradicted fact is that the systems and procedures were deficient. This view is corroborated by the submission made by the State Bank Group. Paragraph 7.3.5, which deals with information systems, summarises the position in the following way:

"Accurate profit reporting for all treasury products in Australia was not available until January 1990. Part of the problem was the state of system development and the reliability of data."

On the evidence described in this Chapter, I find that the systems in use in the Treasury were inadequate, and that because of the emphasis on other aspects of the Bank's business, the attention given to the development of systems was completely inadequate.

Deficiencies in the Bank's systems gave rise to practical problems. Mr Targett said:

"First of all, management information systems around the Bank were so poor -the only way I can describe it, when we had our problems in February this year we had discussions with the Reserve Bank. At that time, talking about the support package, we calculated through our Finance Department what our capital adequacy was and got it wrong, badly wrong. So it really was a lower number and we were sailing closer to the wind in terms of their requirements than what we believed. Therefore, you could assume perhaps that had been going on for a period of time before that." ()

Ms Meeking said, and it is a matter with which I agree, that if the Bank had had better systems that could have shown whether there was an undue proportion of assets in the property market or some other market. If such a disproportion had been shown, it would have enabled the Bank to make a better assessment of its position, but the evidence does not enable me to say whether such information would of itself have been used to avoid the financial debacle that led to this Inquiry.()

While improvements were made to the systems used by Treasury, the evidence is that those improvements were initiated within the Treasury, which bore the burden of the development of the new systems itself. I have not seen or heard any evidence that the Management Information Systems department of the Bank provided any significant assistance to the planning and development of systems in the Treasury. Instead, there is evidence that the Management Information Systems department was resentful of the development of the Heaven software package within Treasury. Mr Macky said the development of the Heaven package proceeded "against my recommendations and requests".() Mr Macky also said:

"I'd been pushing to get some sort of an architecture together, but it's very difficult to get an architecture together when - with Heaven system, for example, I can sit in a meeting with Trevor Mallett and Steve Paddison, and say: I object to Heaven, it is wrong. It's going in on alien hardware, it's not being done according to State Bank standards, it's not being done with State Bank software, it's not being done with State Bank systems, there are no IS staff in it, so that we won't know whether the back-up procedures and processes are correct, we won't know that the disaster planning is correct, and all the rest of it, and was told: well, too bad, Heaven goes ahead anyway.

Heaven was done over my objections. I said, "Wrong, it should not go ahead, it is a risk to the bank, it is a danger to the bank", and I fought Heaven till just about the day I left the bank, on the basis that it didn't have IS staff involved, it wasn't properly documented, it didn't have proper procedures, there was no safety, there was no back-up. I fought the implementation of part of the deal." ()

The other evidence before the Investigation is that the Heaven package has been a most useful innovation without which the Bank could not have achieved the advances in asset and liability management that it has. There is no evidence that any other software system would have enabled the Bank to make the same progress. There are, no doubt, valid reasons for the attitude that Mr Macky adopted, but his evidence does illustrate the hurdles that stood in the path of those who were making efforts to improve the Bank's ability to manage its assets and liabilities. It again demonstrates that there was nobody who was able to take an overview, and arbitrate on what was for the good of the Bank as a whole.

The Peats Report, which recommended the formation of the Treasury Systems Steering Committee, is independent confirmation of the fact that, as at September 1989, there was much to be done in connection with the development of the Treasury systems.

Mr Targett was asked whether the recommendation that a Treasury Systems Steering Committee be established was put into effect. His response was:

"We had a number of gos at doing that, but I guess there was a difference of opinion between the Information Systems people and Treasury in terms of what we needed to do. In the end what we did is work with a small group of people in developing a system for what we considered was our acute priority area which was getting the measurement of that long end swap risk management book, properly measured to mark to market so we got a group of people to work on that as a priority. We did not actually have a system steering committee as such until right at the end of my time there." ()

The system to which Mr Targett referred was, of course, the Heaven system.

Mr Targett was asked whether the Bank ever got the systems in Treasury into order during the time that he spent there. He replied:

"No. I am not sure that any bank does really with the sort of growth we've had in the market. One thing we did manage to do is that we ... developed an in house system called Heaven to mark the swaps in the risk management book to market, and we got to the stage where we got comfortable with the results that was giving us and so we made progress on what we considered was the riskiest part of identification of risk." ()

Generally, Mr Targett did not support the development of systems internally,but he endorsed the approval of the Heaven system on the basis that the Bank "had come a fair way down the track and in the end I think most people found it was the only approach" ()

Mr Targett stated that Heaven was developed by Treasury personnel, with assistance from the Management Information System department. He said it was a matter of "Treasury leading the development rather than M.I.S. leading the development." () That situation produced resentment within the Information Systems department. It was his feeling that the Information Systems people "could not produce".()

The criticism that the Information Systems department may not have been as useful to other departments as they would have hoped is partly explained by the evidence of Mr Macky. He said that the development of the Heaven system was done:

"Against my recommendations and requests, but Heaven proceeded anyway, because that was the style of the Bank."

Mr Macky also said:

"I think it's critical to note right up front during this period that the philosophy of the Bank during the whole period was that the IS Department existed as a service department, and as we got better at costing and as we got better at budgeting, the whole philosophy was that the IS department existed as a break even service department; that is that it provided the service that was requested by its customers and that they were prepared to pay for it out of its budget and just did that and charged back rates that enabled it to break even. The rules were absolutely explicit. The IS department was not allowed to do work that was not budgeted by another department or was not signed off by another department." ()

In fact, if the Information Systems department needed to do internal work it needed approval from executive members to spend the money. Accordingly, the Information Systems department cannot be adversely criticised for not taking an overview of the systems which related to asset and liability management or Treasury. The Information Systems department had no role to play in the overall co-ordination and development of systems within the Bank. In the absence of a request from a user department, the Information Systems department had no specific responsibility.

So far as Treasury was concerned, one possible remedy would have been the formation of the Treasury System Steering Committee which had been recommended in Peats Report. The steering committee was never established because of a difference of opinion between the Information Systems people and Treasury, in terms of what the Bank needed.

On the basis of the evidence before the Investigation the inadequacies of the Bank's information systems simply demonstrate, once again, that there was no person or group within the Bank, which stood above Treasury and the Information Systems department, to co-ordinate their individual requirements and to ensure that the Bank, as a whole, had appropriate systems to manage its assets and liabilities. Such an overview was the joint and several responsibility of the Board of Directors, the Executive Committee and the Managing Director; but they, and each of them failed to discharge it.

On all the evidence, I find that deficiencies in the systems meant that, for most of the period under review, the Board and management of the Bank were deprived of information which would at least have been useful, and was most probably vital for the good management of the Bank.

7.5.14 THE TREASURY AS A PROFIT CENTRE

Although Treasury is primarily a division that provides a service to other divisions of the Bank, there is a potential for Treasury to derive a profit in its own right.

This Investigation has heard evidence that one of the purposes of transfer pricing is to determine the contribution to profit of the different divisions of the Bank, including Treasury. The profitability determined by transfer pricing is, however, a notional profit, arrived at by the subjective allocation of a percentage to the funds that pass through Treasury to other divisions of the Bank. There was agreement that the percentage should be .05 per cent.

In my opinion, no worthwhile purpose would be served for the purpose of this Report by an analysis of that notional profit, because the figure is based on an arbitrary criterion. It is no more than a percentage of the funds required by the operating divisions, and says nothing about the efficiency of the Treasury operation.

The question whether Treasury should be a profit centre was discussed by Mr Paddison in the following terms:

"You either need [transfer pricing] or you need a good reliable well researched benchmark and it has got to be one or the other. Basically the benchmark system needs to be market real. There is also another fundamental policy with a philosophical issue there, and that is the issue about whether treasury is a profit centre or whether it is a cost centre, whether it exists as a cost centre just to raise funds at the lowest possible cost and passed into the lending units at that cost of funds or whether in fact treasury is a profit centre, it passes its funds out at a benchmark, say, market rate level like bank bill, and any advantage it can get from borrowing cheaper or in a different borrowing structure, say, in an offshore market because there is an arbitrage between US raisings funding ratings and Australian domestic funding raisings and that is their profitability." ()

The State Bank never sought to measure the profitability of the Treasury in this sense.

Another way in which a treasury can, and should, make a profit is by its trading activities.

Ms Meeking testified that the profit of a Treasury should be derived from its own activities rather than the agreed margin of funds passing through the Treasury to other divisions of the Bank. She said:

"really there are such opportunities in the financial market it doesn't make sense ... to have a Treasury which is not a profit centre, but I think it is quite appropriate that its transfer pricing to internal sections of the Bank should simply be on a cost recovery basis as far as margin goes."()

Ms Meeking also said:

"... its just not necessary or desirable for Treasury to make a profit out of actually transacting internal business with other divisions but it is appropriate [that] Treasury make a profit by using its skills and knowledge of financial markets, by being to arbitrage financial markets and using its software ... Heaven is, to the Bank, a fantastic competitive advantage. There are not many organisations that have that sort of software available to them and in that particular segment of the market and can put it together with a competitive advantage in being able to raise large blocks of funds overseas in the capital markets. It is the source ... putting that together with the skilled people to run it, terrific opportunity and, in my opinion - ... Treasury has got to justify itself through its own activities in the markets as far as profitability goes, as distinct from cost recovery."()

Ms Meeking said that the profit from trading, in respect of Treasury's own activities, was never measured. If the margin of .05 per cent simply covered costs, whatever profit was reported by Treasury after the totality of all its costs would represent the net result of trading. The components that went to make up the profit were the marked to market valuation of the foreign exchange portfolio; the money market portfolio; the accruals of interest; the realisation of any capital gains or losses on the longer term book before those portfolios were marked to market; and trading from futures transactions.()

The evidence with respect to the profitability of the State Bank Treasury is conflicting. Ms Meeking says that once transfer pricing and the balanced book had been introduced, Treasury was shown to be profitable. That evidence is not consistent with the evidence of others. For example, Mr Copley said that when transfer pricing was introduced that "which everybody has suggested was happening (which) was the treasury was losing money was, in fact, the case." () Mr Targett gave evidence that when he took over the Treasury "it was making no money", and he turned the business during the last six months of 1990 so that a contribution of $7.0M net was made.() He also said "by any measure it was not doing well enough" and that "there were substantial losses on the books that had not been brought to account". ()

The true nature of the profits or losses that the witnesses attributed to the Treasury are not identified. It is not clear whether they are notional profits or losses resulting from the use of transfer pricing; whether they are profits arrived at by a comparison of Treasury's actual performance against a benchmark; or whether they are trading profits or losses.

In so far as they belong to the first or second categories, the profits or losses may be artificial, and there is no point in analysing those profits or losses for the purpose of this Report. To determine whether the trading of the Bank has been profitable would require an analysis of each transaction. That is clearly beyond the resources of this Investigation. In general terms there is no evidence of significant losses having been incurred on the Bank's funding activities.

A system of marking Treasury assets and liabilities to the market is an important aid to the measurement of Treasury profitability. The Report has already referred to the losses that were brought to light when the portfolio was initially marked to the market. Those losses were not caused by the introduction of marking to market but were identified by that system. It is not possible to know when the losses were incurred, or whether there were corresponding profits derived from related transactions which offset the losses. In any event, I do not think that the fact that the losses were identified provides any evidence that Treasury trading was unprofitable.

The Bank's Operating Review for the month of October 1988 shows that, after adjustments had been made from the time when transfer pricing was introduced in July 1988, there was a profit of $3.0M, although the year to date performance was still $1.1M below budget.() Mr Copley accepted that, initially, there were problems associated with the implementation of transfer pricing, and he agreed that Treasury was shown to be profitable, although it was not producing the profits it was expected to produce, in that it was not meeting a budget that had been arrived at by agreement between senior Treasury personnel and the Executive Committee.()

Ms Meeking said, that for the financial year 1988/89 the Treasury recorded a profit of $2.0M or $3.0M over its budget, and that she received a substantial bonus as a consequence.()

The Bank has submitted that the past profitability of Treasury is a matter able to be objectively judged, and that the evidence shows periods when Treasury was profitable and periods when Treasury was not profitable. The Bank submits that the results were not inconsistent with the expectations of such a volatile business area.() There is no reason not to accept this submission as a correct statement of the position.

Accordingly, I have concluded that any more detailed analysis of the profitability of Treasury is not relevant for the purposes of this Report, and such an analysis has therefore not been undertaken.

As I have observed already, the fact that there can be such doubt and such divergent views amongst senior personnel in the Bank on the relatively straight forward question whether Treasury was profitable or not, itself illustrates that there were serious deficiencies in the Bank's accounting and reporting systems.

7.5.15 SOME CONSEQUENCES OF DEFICIENCIES IN THE BANK'S ASSET AND LIABILITY MANAGEMENT

I have already referred to the practice of charging disproportionate fees at the time a lending transaction was entered into at the expense of the interest rate or fee to be charged over the duration of the loan. The result of this practice was to inflate the profit of the Bank in the year the transaction was entered into, but to give rise to the potential for losses in subsequent years.

An assessment by a consultant assisting me with this section of the Report indicates that, without the inflated front end fees, the reported profit of the Bank would have been reduced by almost a third to one half.

In my opinion, the practice of structuring transactions with disproportionate front end fees does have relevance to the losses suffered by the Bank. First, the practice had the effect of artificially inflating the reported profits of the Bank in the first year of the transaction. Accordingly, the reported profits of the Bank could be misleading, so that information being used to manage the Bank was unreliable. To the extent that capital was allocated and individual rewards structured in accordance with incorrectly reported profits, there was a further potential for errors to be made. Secondly, the fact that a disproportionate front-end fee had been taken meant that the transaction may not be profitable in subsequent years. Accordingly, it became necessary for the Bank to grow in order that profits could be reported in subsequent years.

In so far as the practice of taking front end fees was a matter that encouraged growth within the Bank, it was one of a number of factors which helped to create the environment in which the losses ultimately suffered by the Bank were facilitated.

A reasonable establishment fee taken at the time a transaction is entered into can be easily justified. No witness gave any commercial justification for taking a front end fee that is in excess of a reasonable establishment fee, and includes a component that would normally be charged as interest during the full duration of the transaction.

Although there is no evidence (and there is unlikely ever to be), to the effect that the practice of taking the disproportionate front end fees was activated by any ulterior motive, there is warrant for an inference - which I draw without hesitation -that the practice was engaged in with the intention of inflating the reported profits of both divisions within the Bank and the Bank itself. In fact, the legal representatives of certain past directors of the Bank have made that very submission to the Investigation. It was submitted that there were transactions where the whole of the interest was taken as an upfront fee by the Corporate Banking division, although the Investigation has not seen evidence of any such transaction.

Mr Targett gave evidence that "the behaviour that was rewarded was profit for the business units that the people were running" and that "people being quite handsomely rewarded for generating profitability ...". When Mr Targett was engaged by Mr Clark, it was explained to him that if he was able to restructure Treasury and get it profitable, he could expect to be well paid, but if he did not do that, he "could probably expect to get the chop". ()

The Bank has submitted that the comment by Mr Targett is unproved and unconfirmed by objective review. The Bank says that there is objective evidence that executive profit sharing bonuses were based on "pre-specified quanta of group profit over budget, not on divisional results."() The Bank was asked to produce the evidence to which reference is made, but has not done so. I can see no reason not to accept the evidence of Mr Targett. Furthermore, Mr Targett's evidence is corroborated by other witnesses. Ms Meeking, for example, gave evidence that she received a substantial bonus when the Treasury made a profit in excess of its budget for the year 1988/1989.

This Chapter has already considered the fact that up until at least 1988 the profits reported by the different divisions were misleading by reason of the fact that there was no transfer pricing of the cost of funding and overhead expenses. What was reported as profit was no more than the margin achieved on the interest rate. This was a consequence of the Bank accounting policy up until that time.()

Mr Targett referred to inaccuracies in the reported profit of other areas.

He said that in the case of Corporate Banking "there was never a proper measurement of what their cashflows looked like and what their real results were" and that Beneficial Finance "were able to clearly establish their own accounting policies and almost manufacture a profit that they wanted to." ()

He said that the profit reported by Treasury was misleading because it was measured "just in terms of looking at the net number on a piece of paper rather than looking at all of the inherent risks and marking those to market".

He also said that the profits reported by the International Bank were misleading "because it was able to borrow all the cheap wholesale funds as if through having the Government Guarantee the margin that it was able to present in its books was much greater than perhaps what it should have been. If you like they had an inherent advantage through being able to generate the sub-bench-mark funding. So their net result was bigger than perhaps what it should have been if it was measured on a better basis." ()

Mr Targett said:

"In general I think there are quite a few areas across the Bank that promoted a picture that was slightly healthier than what they produced." ()

The practical consequences of the deficiencies in the way in which the Bank managed its assets and liabilities are illustrated by the evidence of Mr Paddison and Mr Targett, with respect to the position at the end of 1990 and beginning of 1991. Mr Targett said he had employed Mr A K Smith from another bank because "I did not feel we had the right skills in terms of the people that were funding the Bank and managing the Bank's risk" in some sections of the market. Mr Smith was perceived to have particular expertise in the area. Mr Targett said that he did work on the Bank's problems, and the more "we delved into it, the more we found the Bank really did not have a handle on its numbers". He said:

"At the time we were also starting to get drains of funding needs coming from Beneficial Finance. So there was a combination of two or three things coming together which indicated that, you know, we certainly had some work to do in that area to try and get the whole picture looked at.

There was not any information that was available at ALMAC or anywhere else which showed us a group picture. There was not any information that showed us a breakdown of what it looked like bedding down International Banking, New Zealand and Australia were sort of one sort of macro report so we really tried to do a lot of work to piece that information together and get a feel for what it looked like." ()

The inaccurate reporting of profit or loss is, of course, a serious accounting problem in its own right. In the case of the State Bank the inaccurate reporting had practical consequences because capital was allocated on the basis of reported profits, and the rewards given to employees were related to the perceived divisional profits.()

7.5.16 PROBLEMS IN TREASURY AT THE END OF 1990

The practical difficulties which Mr Targett as Treasurer experienced during 1990 and 1991 have been touched upon in the section of this Chapter which deals with transfer pricing.

In his statement, Mr Targett refers to difficulties which the Bank was having in funding its operations towards the end of 1990.() Annexure 20 to his statement, is an information paper on the subject of "Liquidity", prepared by Mr Targett. The subject of the document is said to be a "Major Concern", and the text asserts that domestic liquidity was becoming difficult to source at the Bank Bill Reference Rate. The document concludes with this statement:

"It is not in our interests to pay in excess of market rates for liquidity, therefore in the short term, in order to reduce our 11 am book, we may need to:-

(a) impose restrictions on asset creation - purchases

(b) impose restrictions on the amount of funding any division or subsidiary can request on any one day

(c) sell readily liquefiable assets

(d) pass the cost of liquidity back to the areas creating the funding pressure.

Effective immediately, Treasury will require more accurate forecast in the funding needs in order to ensure that the Bank is not placed in a position where a liquidity squeeze could occur."

During early October 1990, Beneficial Finance transferred various assets to the Bank which totalled approximately $600.0M.

The transaction involving the customer which I have called herein "XYZ Ltd" was clearly a matter of concern to Mr Targett. On 17 October 1990, he forwarded a memorandum to the Chief Manager, Corporate Banking (Mr P F Mullins) with a copy to the Chief General Manager, Australian Banking (Mr Paddison), dealing with the matter. The memorandum outlines the funding that Mr Targett had arranged with respect to the transaction. The memorandum then set out a number of matters which Mr Targett described as "Fundamental Issues". They are:

"...

. our cost of funds for term facilities is no longer Bank Bill Flat

. cost of five year domestic funding for SBSA is currently Bank Bill Plus 20

. SBSA could currently purchase 10 year SAFA stock at 30 BP over Bank Bill. This stock is highly liquid and appears to provide better relative return than this deal

. is our motivation for this transaction the political implications of not assisting SAFA, the up-front fee to Corporate Banking (which I assume will be amortised over the life of the deal), or both?

Although we will explore all avenues to "lock in" committed funding against this transaction from May 1991, there is no guarantee that our liquidity situation and resultant cost of funds will improve.

The most fundamental issue is that Treasury cannot continue subsidising Corporate Banking for the cost of liquidity ..."

That memorandum is clear evidence that the Bank was, at that time, entering into a transaction which, in Mr Targett's opinion, was seriously flawed.

In his statement, Mr Targett expanded upon the problems at that time. He said "it was at this point that Steve Paddison and I thought liquidity was going to develop into a problem that needed a group focus". He also said:

"We were at the coalface and could see some of the tiering problems with the paper and the way it was being priced. We had a few mild alarm bells ringing and were trying to make other people see it as well.

The other concern we had within Treasury was that people were writing assets that really weren't appropriate given the funding climate for the Bank. We wanted to bring the whole thing together so that people could see the whole picture, rather than continually lending money when we were having trouble funding it at the right price." ()

It was at this time that the Bank was developing its liquidity policy.

Mr Targett said, in his prepared statement:

"The problem was that the Bank really didn't have any alternatives in addressing these problems and complying with the policy. The off-shore capital markets were becoming less liquid and therefore the committed funds which the State Bank was seeking to access were being priced far more expensively. There would have been a substantial price to pay if we had borrowed some more committed money at this time. Accordingly, we were forced into the short-term market. The Bank's balance sheet was continuing to grow.

The alarm bells were ringing because of these issues and precipitated a change in emphasis only after the draft policy came into existence." ()

Mr Targett also says in his statement:

"It was also of concern to Andrew Smith and myself that the asset creation did not seem to be slowing down." ()

In his evidence to this Investigation, Mr Targett said that there was a problem when the Bank's short-term paper was being priced away from the national operating banks because of a general lack of investor acceptance of the Bank's paper. He said:

"... they were the sort of things that started to make us see that there was only a finite amount of liquidity we could tap into domestically and we needed to make some changes both on the asset side of the Bank and the liability side to get a more structured and more prudent approach to the whole thing. So the alarm bell started from the pricing of our short-term paper in the domestic market." ()

Mr Targett asserted that, notwithstanding his concerns about liquidity, the asset creators in the bank continued to write new business unabated:

"... So they were making the job harder, yes, because it just meant that we had to keep raising money to fund the assets while at the same time buying our paper back to protect our pricing benchmark so it became one of - we really needed to find a way to get more from the off-shore markets to close the gap if you like." ()

Mr Targett was asked whether he had spoken to any other person to enlist support for what he was trying to do. He said his discussions were principally held with Mr Paddison, who clearly understood the position. When asked whether Mr Paddison was in a position to have the lenders modify their activities, Mr Targett responded:

"No. In fact I remember he asked me when I first came onto the Executive Committee - I think it was in October 1990 - to just explain to the Executive Committee the problems that we were having in the market and in fact one of the things I said was that I felt that we should stop writing assets for a while just to get an assessment of where we were and where we wanted to take the thing. The Managing Director at that time said that basically while he was running the Bank we would continue to write assets and so we had to go and rethink our whole method of presenting the problem to people. We slowly made progress but it was not easy because what you would need to understand is that the way the Bank was structured the only real source of profitability was coming from asset writing, so you turn the tap off. The business was so poorly structured that there was no income apart from amount in Treasury and a very small amount in retail, the rest of the Bank was just cost." ()

Mr Targett said that the Corporate Banking division tried to structure transactions so that front end fees were taken to account in order to try and bolster the short-term profitability. He explained:

"The problem with that is that the bigger the fee the smaller your running yield is on the transaction ... It promotes a picture of higher short-term profit but you pay the price over time because of the lower running yield that is feeding your profitability in subsequent years." ()

When it was put to Mr Targett that the only way a profit could be derived in subsequent years was by taking further front end fees, his response was:

"Yes, particularly the way the game was being played. If you cannot get bigger margins from new lending you have got to structure any lending you are doing so that you keep sort of pumping the cash flow through that sort of structure ...". ()

Mr Targett said that transactions were being written at levels which he, in Treasury, regarded as inappropriate because of the margin that was being written into them.

The memorandum of 17 October, to which I have already referred, corroborates the difficulties that Treasury was having at the time, and also corroborates Mr Targett's evidence with respect to his attitude towards the practices that were being adopted in the Bank.

Mr Targett gave evidence that, when he started to put the whole picture together towards the end of 1990, there were signs that the organisation had outgrown the way that the Treasury could safely fund it. He was asked to expand on that statement and said:

"At that time I think we had a group balance sheet of $22-23 billion. As a group Beneficial's asset quality was questionable and therefore we were forced to prop that up by taking assets and raising additional funding. We found that deals like the ("XYZ Ltd") deal were coming through and yet we were having to protect our pricing in the market which indicated that investors were having problems with the quantity of our paper out there and our name and we were forced to really tap into off-shore markets to a fairly large extent on a comparable basis to other banks. So just by a number of measures it just indicated that maybe our organisation had got a little bit bigger than what it should have been on the back of the size retail bank we were and that the money we could raise in a sort of retail sense relative to the size wholesale bank that we had grown to. I just felt that the markets were telling us that it was about time that we stopped growing because it was not going to get us unlimited funding." ()

This evidence of Mr Targett clearly indicates that, notwithstanding the problems that the Treasury of the Bank was actually experiencing at the end of 1990, the operating divisions of the Bank were either unwilling, or incapable, of modifying their behaviour to conform with the requirements of asset and liability management.

 

7.6 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT

 

The evidence and submissions before the Investigation make it clear that there were serious deficiencies in the way in which the Bank managed its assets and liabilities, and in the Treasury operations for the whole of the period from July 1984 until the end of February 1991.

By February 1991, steps had been taken to improve the systems and procedures, but the errors and omissions of previous years could not be rectified overnight. The evidence of Mr S C Targett indicates that, because the operating divisions of the Bank had developed in an environment where no attempt was made to manage the Bank's assets and liabilities, those divisions were not able to modify their practices when the circumstances required it.

7.6.1 TERMS OF APPOINTMENT A

It could not be suggested that the financial position of the Bank was solely and/or directly caused by the way in which the Bank managed its assets and liabilities or conducted its Treasury. For the reasons given in this Chapter, however, the management deficiencies in this area of its operations, when aggregated with other deficiencies examined in other Chapters of this Report, was a matter and event within the terms of paragraph A(a) of my Terms of Appointment. Further, the asset and liability management and Treasury operations of the Bank did, in my opinion, play an important part in the processes which led the Bank to engage in operations which have resulted in the losses and the Bank holding significant non performing assets. It is, therefore, necessary to consider the findings in this Chapter in the light of paragraphs A(b) and (c) of the Terms of Appointment.

In this context, my most significant finding is that, until 1990 there was simply no overall management of the Bank's assets and liabilities. The evidence establishes that this part of the Bank's activities was completely without co-ordination. The emphasis was on growth and profits. As the submission made by the Bank itself observes, it was an organisation that was generally running ahead of its own management resources, capabilities, and reporting systems.() The evidence indicates, that while the deficiencies in the Bank's asset and liability management did not directly cause the losses which are the dominant focus of this Investigation, those deficiencies contributed to the body of critical circumstances in which losses were inevitable.

One could never say precisely what difference it would have made if the Bank had managed its assets and liabilities in a way that was appropriate. There can be no doubt that the Board of Directors, the Executive Committee, and members of senior management, would have been better informed. Whether they would have put that information to use will never be known, but it would have put them in a position to take decisive and effective action to avoid or substantially to mitigate the Bank's losses.

The sort of information that could have been produced included the position of Beneficial Finance, and the concentration of the assets of the Group in property transactions.() There is evidence that, if a liquidity policy had been in place sooner, it may have led to a restriction of the Bank's growth.() In particular Beneficial Finance may not have grown to the size that it did, and the International bank may not have grown to the size that it did. The likely result of better asset and liability management was summarised by Mr Targett in the following way:

"So the end result probably would have been a smaller group balance sheet and if the decisions that would have come out of ALMAC, as you say, the decisions were taken that we were growing a little bit recklessly and I think that that work would have shown us that, [the growth] probably would have been cut back a little bit. Again, the decision would have resulted, should have resulted in the need for the Managing Director to make certain decisions. It would have impacted short term profitability so I cannot say with certainty, with my hand on my heart that he would have said, okay, we can run a smaller balance sheet if it is going to impact income to any great extent. I do not know that but it would have certainly created an awareness." ()

Mr Targett summarised the relevance of problems in Treasury to the losses suffered by the Bank in the following way:

"I think the problems in Treasury was symptomatic of the number of problems that surrounded the whole Bank. One was a lack of executive management expertise, and secondly was a lack of policy and control definition and framework and reporting, and that fed through to, you know, the relationship between Treasury and ALMAC, and the lack of guidelines that were set up there. It was just - you know, the problems in Treasury were just part of a bigger problem across the whole group, and the thing we found is I think we made more of an inroad into getting our part of the business right more quickly because we were able to identify them, but every time in Treasury you sort of ran into an issue that needed to be addressed it usually overlapped the rest of the Bank, whether it was transfer pricing, whether it was this, whether it was that.

The difficulty was just trying to get people to believe they had a problem for a while, and that is why it took longer than perhaps it should have, and playing the politics of, you know, dominant people at a higher level ...". ()

Having regard to the evidence before the Investigation, I accept that commentary as an accurate assessment of the overall position.

On the basis of the matters which are discussed in this Chapter, I have made the following specific findings:

(a) The absence of a cash forecasting system meant that there was an inability to maximise profit opportunities.

The quantification of lost profit is incapable of calculation, because that would require an audit of all the Bank's investment decisions during the period under review. The amount involved, however, is likely to pale into insignificance alongside the losses which are the subject of this Investigation.

(b) The absence of transfer pricing for part of the period under review, and the pricing of transactions by reference to market forces rather than to the cost of funds, meant that the position with respect to unprofitable transactions was never highlighted, and the Board and senior management were deprived of important information.

(c) The reported profits of divisions were distorted by the use of disproportionate front end fees, and by the accounting procedures that were in force. Up until the end of 1988, the reported profitability of Treasury bore no relationship to reality. The "profit" that was reported in the case of Retail Banking and other operating divisions, was not a profit at all, and was no more than an indication of the interest margin that was being achieved. Importantly, the information that was provided to senior management and the Board was misleading, and the directors would not have known what was the profitability of particular divisions.

(d) The investigation has heard direct evidence that the remuneration of Bank officers was based upon the reported profitability and that the reported profit of each of the divisions within the Bank was a matter of importance.

(e) The use of disproportionate front end fees resulted in an undue proportion of the profit on transactions being brought to account in the year that the transaction was entered into, with the consequence that there was the probability that the transaction was, in general, destined to be unprofitable for the remaining years of its life. This phenomenon created an inducement for continued growth.

(f) If the practice of charging inappropriate front end fees had been abandoned, the reported profitability of the Bank would have been reduced by as much as one third to a half.

(g) Up until 1990, the Bank made no attempt to match the maturity of assets and liabilities. This resulted in lost profit opportunities. The reliance on an assumption of predictable behaviour of borrowers and lenders, and an assumption that the Bank would always be able to borrow money to fund any liquidity shortfall was contrary to paragraph 12 of the Reserve Bank's Prudential Statement D1.

The practical consequence of this was the possibility of a liquidity crisis at the end of 1990 and beginning of 1991. Proper asset and liability management techniques would have shown that a dangerous profile of maturities was developing.

(h) The absence of a policy to mark the Treasury portfolio to market prior to 1989 may have given rise to inaccurate reporting as to the value of securities held by the Bank.

(i) The absence of a policy of marking the Treasury portfolio to market enabled the profit on assets to be selectively realised, while losses on corresponding liabilities were allowed to remain hidden.

(j) It should have been clear that the Bank was growing at a rate which exceeded all planning. The growth should not have been allowed to continue in the absence of support from appropriate systems and procedures.

(k) While the growth was evident from a number of sources, including the balance sheet, proper asset and liability management would have resulted in information from Treasury about the nature of the growth such as its volatility, the nature of the assets, and their redeemability, in relation to the liabilities which were funding them.

(l) Because of the lack of staff with appropriate experience, there was no overall planning of the Bank's asset and liability management and Treasury. (Indeed, as Mr G S Ottaway said, the intention was that the Treasury should be evolutionary, in the sense of being responsive to needs). For these reasons, the necessary policies and procedures were not put in place at the outset.

(m) The first ALMAC was a failure.

(n) There was no entity or person with effective overall responsibility of asset and liability management until 1990.

(o) Until 1990, there was no apparent effort to approach asset and liability management on a group-wide, as opposed to a Bank only, basis.

7.6.2 TERM OF APPOINTMENT C

By Term of Appointment C, I am required to investigate and inquire into, with reference to the preceding Terms of Appointment, whether the operations, affairs, and transactions, of the Bank and the Bank Group were adequately or properly supervised, directed, and controlled, by:

(a) the Board of Directors of the Bank;

(b) the Chief Executive Officer of the Bank;

(c) other officers and employees of the Bank; and

(d) the Directors, officers and employees of the members of the Bank Group.

7.6.2.1 The Board of Directors of the Bank

In considering the Board of Directors of the Bank for the purposes of this Chapter, I have considered the Board as a group, and the comments I make relate to that group, rather than to any individual director. Without analysing the position of each director, including his or her training and experience, exposure to the activities of the Bank and actual participation in the activities of the Bank, it is not possible to discuss the position of particular directors with respect to this area of the Bank's operation.

Sub-section 15(2) of the State Bank of South Australia Act 1983 provides:

".. .(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."

Accordingly, the position of the Board must be considered both in the context of Term of Appointment C, namely whether the operations, affairs, and transactions, of the Bank and the Bank Group were adequately or properly supervised, directed, and controlled, and in the context of the requirement of sub-section 15(2), namely whether the Board administered the affairs of the Bank "in accordance with accepted principles of financial management and with a view to achieving a profit". In practice the difference between the two criteria may be one of semantics only, although they may both differ from the test to be applied when assessing the common law and statutory duties of directors.

There is an abundance of evidence before me that the Directors took no active role in the asset and liability management of the Bank. Having regard to the backgrounds of the respective members of the Board, it is unlikely that they had occasion to become aware of the subtleties of asset and liability management. None of the Directors is likely to have been in a situation where they would have been exposed to an asset and liability management function of the type that was required by the Bank. Mr Targett gave evidence that he attended a Board meeting in June 1990 and formed the impression that the Board did not understand treasury operations.() The evidence of Mr Paddison is to the same effect.

Mr D W Simmons gave evidence disputing the statement that there is no evidence that the Directors took an active role in the asset and liability management of the Bank.() He said there was a section in the group operating reviews on Treasury and asset and liability management and that Mr Mallett, and subsequently Mr Targett, attended Board meetings, where they gave presentations in relation to Treasury, and ALMAC matters and answered questions.

Mr Barrett also gave evidence disputing that the Directors took no active role in the asset and liability management of the Bank.() Mr Barrett said that the Board always realised the importance of matching assets with liabilities.

Mr Barrett and Mr Simmons believed that the asset and liability management of the Bank was being properly attended to. I accept the evidence as to their respective beliefs. There is, however, no evidence that the Board of Directors effectively made any positive contribution to the asset and liability management or Treasury operations of the Bank.

Mr K J Hancock provided evidence that the Board did take an interest in specific aspects of asset and liability management which included the issue of swaps. He said he made an assiduous effort to understand them, and satisfy himself that they were being used properly. He also said that another issue was the inability of the Bank's retail business to support its growth, and the Board considered that matter in approving the use of wholesale borrowing. Mr Hancock says that the Board was not aware of any problem in Treasury, and that it is not clear to him what should have been done, other than relying on management advice to discover any problems.() I accept Mr Hancock's evidence that this was the view genuinely held by him on this matter.

It is universally accepted that asset and liability management and treasury operations are esoteric areas.

It is clear that Mr Barrett, Mr Simmons, and Mr Hancock, genuinely but mistakenly believed that the asset and liability management and Treasury operations of the Bank were being properly conducted.

Mr Mallett gave evidence to the effect that the Board of Directors was dis-interested in the topic of asset and liability management. He says that he provided the Board with a booklet containing twenty questions which the Board should ask about ALMAC but that he never received a single response. He also said that he did not see anything to indicate that the Board was concerned to see that an appropriate infrastructure was put in place to support the growth which was taking place in the Bank.()

Mr Mallett says that he was never told of any decision or initiative by the Board which related to the management of the Bank's balance sheet in the overall sense and that he never learned of any decisions by the Board with respect to the Treasury operations of the Bank. He said.

"With the greatest respect I think it is fair to say with the benefit of Hindsight the Board never understood the Bank's Treasury operations. I didn't really become aware of that not necessary in the last year but in late 1990 when the Chairman of the Bank went to London and got extremely upset because London told them they still did certain foreign exchange transactions, and said he never knew that London was involved in foreign exchange and yet he had been actively approving foreign exchange trading limits for London for the past 7 years.

That is when I really understood the Board had no idea. With respect they don't need to have a lot of idea, but I think they should have understood the basics between what is a trading limit for, to let you trade in foreign exchange. So with the benefit of Hindsight today I don't think the Board had as good an understanding as I thought they did about the Bank's Treasury operations." ()

There is a large volume of evidence which suggests that the members of the Board of Directors did not fully understand the Treasury operations or the asset and liability management of the Bank. I do not think that anyone can criticise the individual directors for that. It is universally accepted that Treasury operations and the principles relating to asset and liability management are specialised and complex matters. They were areas where the Directors were very heavily reliant upon the advice which they received from senior employees, particularly those who had been employed as specialists in the area.

There is evidence that the directors were dis-interested in the topic of asset and liability management. The minutes of the second ALMAC indicate that a seminar was arranged to be conducted by Mr Myers of the Sendero Corporation but that only two of the directors, namely Mr Simmons and Mr Nankivell attended.() In addition, Mr Targett gave evidence that he developed a risk profile paper for the Australian Treasury business and that he called each director and asked whether he would like Mr Targett to explain the document to them. None of the other directors took Mr Targett up on that offer. Mr Targett also said that Treasury offered to explain the treasury operations to the directors over a working lunch where he and other people from the Treasury could describe Treasury activities. He said he wanted the directors to understand so that they could be comfortable and supportive but that "unfortunately they did not have the time to take us up on that offer".

Although I have reached the conclusion that it is unreasonable to expect the Board to be familiar with the intricacies of asset and liability management, that does not mean that they had no role to play. This Investigation has heard evidence of a number of specific important areas where the activities of the Bank lacked direction and co-ordination. Most importantly, there was no attempt to put in place a proper asset and liability function or a liquidity policy until 1990. The position of the Group, as opposed to the position of the Bank alone, did not come under Board scrutiny until far too late.

The Board permitted the first ALMAC to be dissolved without a proper substitute being put in its place. That fact alone clearly indicates the lack of importance that the Board attributed to asset and liability management at the time. There was no co-ordination of the separate treasuries that developed.

Mr Simmons gave evidence about the dissolution of the first ALMAC. He said it was presented to the Board as a fait accompli. He believed that Treasury was taking over the responsibilities of ALMAC.() During the period from July 1987 to June 1988, when there was no ALMAC, Mr Simmons believed that Mr Copley's department was handling the duties and responsibilities that had been previously handled by ALMAC.() Mr Simmons was surprised to learn that the first ALMAC was really only a pricing committee. He was under the impression that the ALMAC Committee was responsible for a lot more than pure pricing.() Mr Simmons said that if contrary to the belief of the Directors, the task of asset and liability management was not being conducted appropriately, that was a consequence of the esoteric nature of the area and the fact that the Board were not kept fully informed by members of senior management.()

Mr Barrett said that the Board endorsed the dissolution of the first ALMAC because it accepted Mr Clark's advice that it was appropriate. He believed that Mr Copley and the Finance department was responsible for the overall management of the Bank's assets and liabilities after the dissolution of the first ALMAC.() He disputes the statement that there was no person or committee personally charged with the responsibility.()

I have no reason to doubt that the Board members held genuine beliefs that the asset and liability management and Treasury operations of the Bank were being properly handled. The evidence before this Investigation, however, clearly establishes that such a belief was erroneous.

In my opinion, a prudent Board would, having regard to the fundamental importance of this activity in the operations of a banking business, have taken steps to obtain a better understanding of the intricacies of asset and liability management and the Bank's activities in that area. In my opinion, it was not sufficient for the Directors to permit themselves to remain in ignorance of the reality of the situation. It is not possible to say that any particular Director should have taken any particular action. That does not mean, however, that the Board as a whole did not have an important role to play. The real problem was that none of the Directors had the knowledge or experience of banking practice that was necessary to understand what was required in the area of asset and liability management and to realise that what was being done by the State Bank in that area was seriously inadequate.

On all the evidence, I have no alternative but to conclude that the Board (as an entity) did not administer the Bank's affairs in accordance with accepted principles of financial management as required by Sub-Section 15(2) of the Act and in so doing was in breach of its statutory responsibilities.

In this matter, in my opinion the operations, affairs, and transactions, of the Bank and Bank Group were not adequately and properly supervised, directed, and controlled, by the Board of Directors of the Bank.

7.6.2.2 The Chief Executive Officer of the Bank

Mr Clark was also a director, and all of the comments which I have made with respect to the Board of Directors generally, apply specifically to Mr Clark in his role as a director.

As Chief Executive Officer, he was the one person in a position to take an overview of the whole of the Bank's activities. Indeed, that was one of the main reasons for the existence of his position. The evidence before me indicates that there are many areas in which the activities of the Bank lacked direction from Mr Clark and the senior management of the Bank.

Mr Clark was a dominant personality, and had substantial influence on both the staff who reported to him, and the Board of Directors.

Notwithstanding his undoubted ability in many other areas, the evidence is clear that he displayed neither sufficient interest, nor an appropriate level of expertise, for the Chief Executive of the Bank in the area of asset and liability management.

As a consequence he did not give the impetus that this important area required. Indeed, to the extent that his emphasis was on growth and reporting profits he appears to have denied that it was an important function.

Notwithstanding his memorandum to the Board of June 1984, he did not pay heed to matters which he had declared to be important, and he was the motivating force behind the dissolution of the first ALMAC.

Contrary to what is regarded as an essential practice, he did not involve himself in the affairs of the asset and liability management committees.()

Mr Clark has said that Treasury operations were not his area of expertise, and that it was for that reason that he appointed Mr Hazel. He says he "supported the request of Mr Hazel for whatever specialist staff he required."() Mr Hazel has independently made a submission to the contrary.() Mr Clark says that Mr Hazel had been recruited from another bank, where he was director of operations, and that he had put himself forward as very knowledgeable in the Treasury area. His solicitors have submitted that, whilst Mr Clark must take ultimate responsibility for all of his executive staff, Mr Hazel's failure in the Treasury area was not reasonably foreseeable. I accept that submission. It does not, however, exonerate Mr Clark. As Chief Executive he had an ongoing duty to oversee the operations of the Bank. He failed to take steps to inform himself as to the actual position and simply assumed that the Treasury operations were in order. He should have been more involved in the asset and liability management of the Bank as this was a function of fundamental operational importance. What minutes of the first ALMAC have been located indicate that Mr Clark rarely attended meetings. On all the evidence, I find that Mr Clark should have supervised the matter of asset and liability management of the Bank and that he failed to so.

Mr Clark's solicitors submitted that he believes that he had appointed people who were "competent to run the operation" and that when it was obvious that was not so he was instrumental in bringing qualified people in from outside.() The Inquiry has not heard any evidence to support this submission. First, there is no evidence of an awareness that asset and liability management was not being conducted appropriately. Mr Hazel was promoted to be Managing Director of Ayers Finniss. He was not replaced because of any concern about his competence. He was replaced by Mr Mallett and Mr Paddison, both of whom were existing employees of the Bank with no experience in asset and liability management. The submission is rejected.

The desire to achieve growth and make profits are not by themselves objectionable. The evidence indicates, however, that, by 1990 and 1991, the practice of taking disproportionate front end fees had denuded the Bank of its ongoing profit stream. It was, therefore, necessary to grow so that further front end fees could be reported simply so that the Bank could be seen to be operating profitably.

Some of the transactions that were being entered into in order to achieve this result may in themselves have been unprofitable. For example, the evidence of Mr Targett implies that was the position with the customer which I have called `XYZ Ltd'.

One of the reasons for the inadequacy in the way that the Bank managed its assets and liabilities was the lack of appropriately skilled staff. To the extent that he insisted on the appointment of Mr Mallet in the face of an objection from Mr Hazel, Mr Clark failed to supervise, direct, and control, the affairs of the Bank in an appropriate way. All in all, he simply did not give asset and liability management the emphasis it deserved.

The proliferation of Treasury operations, with no co-ordination of the activities, is another area where Mr Clark was the only person in possession of all the relevant organisational and operational facts and in a position of authority such as to enable him to co-ordinate the Bank's activities; but there is no evidence that he did so.

Mr Clark says that, on the dissolution of the first ALMAC, Mr Copley assumed responsibility for the overall co-ordination of management of the Bank's assets and liabilities. Mr Copley denies that fact. In any event, the evidence is clear that there was no overall co-ordination of the task. Again, it was Mr Clark who was in a position to have acted, but he appears not to have been aware of the existence of any shortcoming.

Several witnesses referred to the absence of co-ordination of the Bank's information systems.() This is yet another area where Mr Clark failed to give direction from the top.

In addition, there is evidence that the policies of Mr Clark were a contributing factor in the losses which have been suffered by the Bank. The policy of growth and the policy of taking front end fees are examples of such matters. There is also the specific evidence of Mr Targett with respect to the transaction involving "XYZ Ltd". That transaction illustrates the inappropriateness of the policy of growth at a time when liquidity for the Bank had become tight.

7.6.2.3 Other Officers and Employees of the Bank

The evidence before me indicates that the operations, affairs, and transactions, of the Bank in connection with asset and liability management, and treasury operations, were not adequately or properly supervised, directed, and controlled.

A significant factor in that finding is that the staff had insufficient training or experience to qualify them for the positions which they held. One cannot be critical of the employees for such shortcomings.

When Mr Mallett was employed to head the Treasury, it was pointed out to Mr Clark that Mr Mallett was inappropriately qualified. At that time, the Treasury operations had become quite sophisticated. Mr Clark's persistence in appointing Mr Mallett, in the face of the opposition of Mr Hazel, and Mr Mallett's own acknowledgment of his inadequacy for the task, evidenced the inappropriateness of his appointment.

In answer to evidence of Mr Paddison that Mr Hazel was "a dealers dealer, not a general manager," and that he had just traded and not put proper systems and procedures in place(), Mr Hazel's solicitors have submitted that he did not just trade, but established rudimentary asset and liability management procedures which were not being followed by anyone else.() They refer, by way of example, to the marketing of funds used in connection with a "fixed rate loan produce" [sic] and the way in which the increase yield was managed to benefit the Bank's interest margin. They also submit, on Mr Hazel's behalf, that asset and liability management "was hindered by not having the capacity or systems to comprehensively manage the asset and liability [sic] of the Bank". In addition they say that ALMAC had been formed to manage the Bank's assets and liabilities and that responsibility for asset and liability management rested with that Committee.

I accept that Mr Hazel did more than just trade. There is evidence that he did much good work, such as establishing the Bank's capital market programme off-shore.() I also accept that ALMAC should have played a greater role in asset and liability management. All that does not mean however, that Mr Hazel could not have played a more active role in the development of the Bank's asset and liability management function. He was a member of ALMAC from November 1985 on, and should have been aware of its shortcomings. He had been specifically employed to head up and add expertise to the Bank's Treasury operations. Mr Clark relied heavily on him.() He was the member of the senior management of the Bank who was in the best position to plan and direct the development of the Bank's asset and liability management. On all the evidence, I have concluded that Mr Hazel did not do as much as a person in his position should have done to plan and implement proper systems and procedures.

7.6.3 TERM OF APPOINTMENT D

For the reasons which are discussed above, I have come to the conclusion that the information provided to the Board with respect to the asset and liability management and Treasury operations of both the Bank and the State Bank Group was neither timely, reliable, adequate or sufficient to enable the Board to discharge adequately its functions under the Act.

Without analysing all of the information which was provided to the Board during the period under review, this conclusion is clearly demonstrated by contrasting the information which was provided on asset and liability management at the end of 1990 with the information which had been provided previously.