By BILL BLEVINS [email protected]
Bill Blevins is Managing Director of Blevins Franks. He has specialised in expatriate investment and tax planning for over 35 years. He has written books and gives lectures on this subject in Southern Europe and the UK.
One of the greatest issues which investors face is understanding risk. The biggest misunderstanding is between institutional risk and investment risk.
Institutional risk, otherwise known as credit risk, is whether the company or institution will fail. Investment risk is the risk to the return you will make and whether your assets will rise or fall in value.
This week’s article covers institutional risk. Next week I’ll discuss investment risk.
A good example of institutional failure is former US bank Lehman Brothers. It failed because of poor banking practices despite having an AA credit rating right up to the day it declared bankruptcy.
Towards the end of October, the International Monetary Fund warned that more European banks “may fail”. Private funding is “virtually unavailable” and banks will have to rely on public intervention, asset sales and consolidation.
One of the key fundamentals of investing, irrespective of whether we’re talking about institutional risk or investment risk, is the concept of the ‘risk free rate’. This is the Bank of England (BoE) base rate. Since the BoE is regarded as being as safe as you can get, by definition the rate of interest it offers is risk free.
By contrast, if you invest in any bank which offers you more than the ‘risk free rate’, you are taking an element of risk that the institution may not be able to give you your money back.
Over the years, the risk of banks defaulting has been low, however, as we’ve witnessed over the last year or so, the risk became very high. As a depositor, you are nothing more than an unsecured creditor of the bank. Many banks’ borrowings exceed 40 times their capital. So for every £1 of capital, they’ve borrowed £39. The ratio of borrowing to capital is called leverage or gearing.
Any banking institution offering you more than the ‘risk free rate’ will come with some risk attached. As a general rule, the higher the interest rate on offer, the greater the risk. Just before it went bust, Kaupthing Singer and Friedlander were paying the best interest rates. Chasing the highest rate has proven to be a dangerous game.
Institutional risk is not confined to banks; it potentially affects each and every institution albeit in slightly different ways.
Given everything that’s happened recently, every investor should now ask their adviser, bank or life assurance company to prove exactly how they are protected, and to what extent, in the event of institutional failure. You can then understand the risks and decide accordingly.
Within Europe, the level of investor protection from institutional failure varies significantly between each country and type of institution – e.g. bank, insurance company etc.
The level of protection ranges from nil to 100 per cent protection and with no upper limit. Luxembourg-based insurance companies benefit from the latter and their tax sheltering products are available in other EU countries.
In all cases, you should seek professional advice from an authorised advisory firm.
The risk of investors being defrauded still exists, irrespective of the tightening of regulation.
One of the most common types of financial frauds are Ponzi schemes. They offer very attractive returns to encourage others to invest. Behind the scenes, however, the money is not being invested and returns are being provided by giving investors their own money back. Once the fraudster has built up sufficient funds, they typically run away with the money, leaving investors with nothing.
Other types of potential fraud include deliberate misrepresentation. The story behind them seems plausible but the reality is somewhat different. There are no free lunches and if anything looks too good to be true, then it probably is.
Always remember the “risk free rate” and that it’s really not possible to generate high returns from something that is low risk. If a low risk investment is promising high returns, this usually means it’s either higher risk than you realise or you’ll only ever receive low returns from it.
Some simple rules to avoid the potential of being defrauded:
If the return being promised is more than the ‘risk free rate’ then you are taking a degree of risk. There is no such thing as financial alchemy.
Only ever deal with authorised and regulated companies and advisers.
Only ever transfer your money to an authorised institution or trust company.
Never transfer funds to an unauthorised company who say they will invest it on your behalf into an authorised company. If you’re dealing with a fraudster then it’s unlikely to get there.
Ask yourself: why can this investment pay so much more than any other? There has to be a catch.
On December 12 Bernard Madoff was arrested for a Ponzi fraud of “epic proportions”. He ran a hedge fund whose numbers were too good to be true for too long, even making positive returns when the market was incredibly volatile. It looks like the largest fraud ever in corporate history. We’ve always been suspicious of hedge funds because of the lack of regulation and transparency.
Next week I’ll look at investment risk and explore why it’s not constant, eg how the same bank account can be low, medium and high risk at the same time, depending upon the investor’s objectives. I’ll look at how a diversified spread of assets can reduce risk and enable investors to meet their long term objectives.
To keep in touch with the latest developments in the offshore world, check out the latest news on our website www.blevinsfranksinternational.com