The collapse of State Bank Victoria and Tricontinental

This is an assignment I wrote for Management of Financial Institutions, one of the ten subjects in Macquarie University’s Master of Applied Finance. It carries no date of its own; the file was last saved on the 29th of October 1993, and the subject is the one that won me the Australian Institute of Bankers Prize. The manuscript has no title either — the one above is mine, and it opens straight into “Introduction”.

I am not a disinterested witness. I was a Treasury Analyst at State Bank Victoria until the merger with the Commonwealth Bank, so the section of personal observations is first-hand, and the ex-colleague quoted in it is left unnamed here as he is in the manuscript. One detail in that section does not survive checking: it says I joined SBV’s Sydney Treasury in early 1989, where three of my own CVs from 1995 and 1997 all give 1990 to 1991. The assignment is reproduced as written and the discrepancy noted rather than corrected.

The five points at the end of that section are labelled in the manuscript as rumours, reported as an ex-colleague’s answer to a question over lunch, and they are reproduced with that framing intact. The Royal Commission into the Tricontinental Group of Companies reported after this was written; nothing here should be read as its findings.

Set from the Word 2.0 manuscript. Its seven footnotes are gathered at the end rather than kept at the foot of each page, and the words are otherwise as submitted.

Download the original assignment (DOC, 19 KB)

Introduction

The 1980s was a turbulent decade for the Australian financial industry. Asset prices and stock prices were growing at phenomenal rates, and the smell of money reached the noses of many opportunistic entrepreneurs, who envisioned a fortune to be made by borrowing up to the hilt to invest in assets that grew faster than compounded interest rates. At the same time, the deregulation of the banking industry and the subsequent entry of foreign banks into the industry meant that there were many lenders who were prepared to relax their credit policies in order to pursue a larger share of the market.

The stage was clearly set for an explosion in credit activity.

In the meantime the Victorian government was keen to pump prime the state economy by setting up state trading enterprises, such as the Victorian Economic Development Corporation (VEDC). The State Bank of Victoria (SBV), a venerable savings institution set up in 1851 and long regarded as a cash cow to the state’s coffers, was increasingly seen as a dour institution with a public service mentality.

Up until then, SBV was a conservative financial institution focusing almost exclusively on retail banking. It operated quite successfully within the framework of restrictive regulations surrounding banking activity. With the onset of banking deregulation, the State Government of Victoria obviously concluded that the bank needed a fresh new image and an expansion into the exciting new world of international, entrepreneurial financing. This will enable SBV to compete with the increased competition, both from the established major banks as well as the new foreign entrants.

In 1983, Premier John Cain hired Merrill Lynch to define a long term strategy for the bank, and the resultant report merely ‘confirmed’ the government’s belief that SBV should expand beyond its traditional retail banking activities by pursuing the medium-sized corporate borrower. The end result was the hiring of Bill Moyle as SBV’s first outside chief executive and an equity investment in Tricontinental, a merchant bank specialising in corporate lending.

Strangely enough, SBV’s involvement in Tricontinental came almost by accident. An earlier joint venture, Westralian, got into trouble and the rescue package involved Tricontinental taking it over and SBV emerging as a shareholder of Tricontinental. A plan to sell its equity holdings to Mitsui, a Japanese bank, fell through¹ and SBV emerged as the sole owner of Tricontinental.

SBV still had high hopes of eventually selling Tricontinental for a tidy profit, so on a fateful day in 1985 the SBV board decided to allow Tricontinental to become as independent from its parent as possible, with its own board, managing director and operational procedures. Accordingly, Ian Malcolm Johns was hired as the managing director of Tricontinental in early 1986. The only link between SBV and Tricontinental were at the board level. Two SBV executives, Jim McAnany and John Rawlins, were Tricontinental board members.

I believe that this single, monumental, decision was the root cause underlying the subsequent debacle, which eventually helped to cause the resignation of many of the most senior members of the Victorian Labor Government, including its Premier and Treasurer. It allowed a culture to develop within Tricontinental that was largely unchecked and uncontrolled by SBV or government regulators. This culture promoted reckless lending. When the risks associated with Tricontinental’s activities finally surfaced, they were powerful enough to cause the collapse of Tricontinental and eventually the sale of its parent SBV to Commonwealth Bank of Australia.

The factors behind SBV’s downfall

SBV was not regulated by the Banking Act 1959 but by the State Banking Act, hence it did not fall within the prudential supervisory responsibilities of the RBA. In any case, the RBA prior to the amendment to the Banking Act in 1989 did not have the wide range of prudential supervisory powers that it has today and the BIS Capital Adequacy guidelines in the heady days before the October 1987 crash were still being debated. Neither AFIC nor ASC existed then, so SBV was comparatively lightly regulated and Tricontinental, as a non-bank financial institution (NBFI) owned by a state bank, was largely unregulated.

On top of this, there was some confusion as to who was ultimately responsible for the bank’s decisions. Premier Cain and Treasurer Jolly thought that the RBA was monitoring the bank’s activities, and limited direct contact with SBV to an annual meeting with the board. On the other hand, the RBA thought that the Premier had control.

In short, there were a number of factors underlying both SBV and Tricontinental that by today’s standards would be a recipe for disaster:

Both SBV and Tricontinental were growing rapidly, both in terms of company size and the size of the balance sheet. Neither of them were immune to the pressures facing the major banks to increase market share, whatever the cost.

SBV was diversifying into unfamiliar areas of business, in particular corporate lending. Tricontinental was a merchant bank that specialised in corporate lending. Hence the group as a whole was developing a double exposure to an area of financial activity that had proved to be extremely unprofitable for even the major banks during the 1980s.² Corporate lending is now recognised to be a business with limited upside but large potential risks but in the heady days on the 1980s it was considered to be the new frontier in banking. It certainly attracted a lot of competition between many players, including the major banks, foreign banks, merchant and investment banks and finance companies.

Tricontinental appears to be dominated by a single individual, its managing director Ian Johns.

The link between SBV and Tricontinental occured only at the board level, and SBV staff had little knowledge nor access to details on Tricontinental’s portfolio. In fact, as noted by SBV’s 1989 Annual Report, “… the types of services offered by the Bank and Tricontinental were increasingly overlapping.”

Tricontinental’s mistakes

Unfettered by restrictive lending policies and any form of control or monitoring from either its parent or market regulators, Tricontinental immediately went on a lending spree. Large sums of money were lent to companies with dubious repayment abilities and when problems occurred, particularly after the October 1987 stockmarket crash, Tricontinental either ignored the signals or obligingly restructured the loan agreements which often increased their exposure to the defaulting borrower. Tricontinental’s loan portfolio looked like a roster of infamous corporate failures of the late 1980s.³

At the same time, other merchant banks were trying to withdraw from lending altogether due to rising funding costs and increasingly stringent capital requirements which made it harder to write profitable loans.

In hindsight, it is of course easy to criticise Tricontinental for their reckless lending. However, it is the function of financial institutions, including merchant banks, to acquire, absorb, manage and price risk. It can be argued that Tricontinental’s behaviour is consistent with their stated aim of servicing high risk corporations. After all, there can be no profit without risk taking. In retrospect, Tricontinental’s fault may be attributable to them acquiring a level of risk beyond their capacity to manage competently.

One factor which may have exarcebated Tricontinental’s lending activities was its renumeration structure, which rewarded loan officers based on the amount of new loan business generated. Little consideration was placed into the quality of loans written and actions towards a proper risk-return analysis and portfolio diversification were not rewarded. Hence the loan officers were biased towards a short term view of lending and a disregard for credit control procedures.

In fact, Tricontinental’s lending strategy was underpinned by the assumption that asset prices will continue to outgrow any increases in the cost of funding. The collapse of equity and property prices in the late 1980s, coupled with the tightening monetary policy soon undermined the strategy, in addition to inadequate credit control and monitoring procedures and insufficient provisioning charges.

Tricontinental may also not have priced the risk of entrepreneurial lending correctly. Certainly the fees charged in some cases were exorbitantly high, but perhaps not high enough. In this respect, Tricontinental may not have been the only player in the market who mispriced risk. Lending to high risk corporates and small businesses have traditionally been dominated by the finance companies, with their unique credit culture of close monitoring of their borrowers and officers who understood the cash flow peculiarities of small businesses and risky enterprises. These finance companies typically charged interest rate margins of around 300-400 basis points to borrowers. Post deregulation, most new entrants lending to high profile entrepreneurs, including the major banks lending in their own name and the foreign banks, charged margins of only 150-200 points and in many cases did not factor administration and loan enforcement costs properly into their lending margins.

Another reason was Tricontinental’s actuarial base, which was probably not sufficiently diverse enough to buffer the risks taken. The concentration of Tricontinental’s loan portfolio with a few high profile entrepreneurs and corporations⁴, coupled with their lack of focus in other areas of traditional merchant bank activities such as securities trading and market making, meant that Tricontinental was not resilient enough to withstand unforeseen events. Losing money in the process of seeking a profit is not necessarily a sign of bad management, but in Tricontinental’s case it did not have a sufficiently broad actuarial base to cushion the default of a major borrower nor a capital base large enough to cushion the loss of income.

Tricontinental was, like some of the foreign banks, relatively undercapitalised. Part of the problem was an attitude, widespread amongst the market and also within Tricontinental, that because Tricontinental was guaranteed by SBV⁵ which was in turn guaranteed by the State Government of Victoria⁶, it was essentially lending against a much larger capital base. However, SBV was largely unaware of the size and risk of Tricontinental’s portfolio and hence was not allocating additional capital against Tricontinental’s loan writing. In any case, SBV itself would have been considered undercapitalised according to the BIS capital adequacy guidelines.

In other words, Tricontinental broke just about every rule of corporate lending risk managment, as espoused by Richard Sheperd of Macquarie Bank:

Tricontinental did not have strong credit checking or control procedures. In fact Tricontinental’s auditors, KPMG, at one stage recommended the replacement of the head of its credit area.

Tricontinental’s credit checking was not independent of its loan writing.

Tricontinental often lent to risky enterprises without adequate collateral.

Tricontinental often broke it’s own lending guidelines and credit control tenets.

Tricontinental failed to monitor the status of loan repayments and financial situation of borrowers. A 10 day study of its credit area in 1988 detected more than 90 monitoring errors.

Tricontinental had a culture that promoted short term performance with little regard for risk management.

Tricontinental’s strategy was largely based on portfolio growth rather than profit maximisation.

Tricontinental failed to act quickly enough when borrowers broke loan covenants.

The finale

In May 1989, in the wake of a public scandal over the amount of Tricontinental losses due to bad debts, SBV took full managerial control of Tricontinental, after scrapping plans to merge Tricontinental and Australian Bank with an accompanying float. SBV provided guarantees of indemnity⁷ and also raised $500 million in note issues to the European market in order to meet the BIS capital adequacy requirements.

Integrating Tricontinental into SBV’s corporate lending division was not easy. The investigation of the status of Tricontinental’s loan portfolio took time and yielded fluctuating bad debt estimates. The collapse of notable borrowers such as Qintex and Abe Goldberg increased the the SBV group losses until in March 1990 the losses were in danger of exceeding SBV’s shareholders’ funds.

SBV’s board was sacrificed, but by then it was too late. A possible merger between SBV and the State Bank of NSW was mooted, but was quickly vetoed by Premier Greiner of NSW. Finally, in August 1990 the assets of SBV were sold by the new Premier of Victoria, Joan Kirner, to the Commonwealth Bank. Westpac was rumoured to be the only other bidder. The taxpayer of Victoria were left with the burden of shouldering the losses.

It could be argued that the mistakes and bad judgements that SBV and Tricontinental made were no worse or better than those made by its competitors. Perhaps if Tricontinental had been owned by a more richly endowed parent it would have been discreetly buried and forgotten, like Partnership Pacific, National Australia Ltd and Elders Finance. In any case, the political and economic circumstances, coupled with the very unique relationship between SBV, Tricontinental and the people of Victoria and its government, created the chain of events that we know today.

Some personal observations

I joined the Sydney division of SBV’s Treasury in early 1989, into an area that was once Australian Bank’s treasury operations but has since merged with SBV’s Treasury. The Treasurer, John Rawlins, was my boss’s boss’s boss, if I recall correctly. In my infrequent trips to Melbourne, I was constantly reminded of the fact that the heart of SBV was pretty much still that of a provincial retail bank. Many areas of the bank were still heavily focused towards retail banking and, apart from the injection of expertise brought by staff from Australia Bank who dominated SBV’s Treasury, very few people in the Bank was aware of banking business other than retail banking. Consequently, the events surrounding Tricontinental and SBV’s own corporate lending defaults came as a major shock to many of the bank’s staff.

Recently I had lunch with an ex-colleague of SBV, still working in the Commonwealth Bank, and asked him what he thought was the major causes of the SBV/Tricontinental. He gave his top five reasons, which are as follows:

The fact that SBV was regulated by the State Banking Act and not by the RBA.

The fact that SBV was guaranteed by the Victorian State Government, and that the market perceives Tricontinental as being guaranteed by SBV.

The rumour that Tricontinental was authorised to lend against SBV’s capital base.

The rumour that the RBA sent warning letters about Tricontinental to SBV as early as 1987, which were not acted upon by SBV.

The rumour that both Rawlins and McAnany resigned from the Tricontinental board because of disagreements over Tricontinental’s lending strategy, which broke the link between SBV and Tricontinental.

References

State Bank Victoria 1989 Annual Report

Martin Summons, Tricontinental’s bad loan book unfolds, Australian Business 2 August 1989

Robert Gottliebsen & Tim Boreham, The Mistake behind Trico’s Disaster, BRW 20 October 1989

Kenneth Davidson, Victoria: What Went Wrong?, ALR June 1990

State Bank Victoria 1990 Annual Report

Gideon Haigh, The Bank That Buried Victoria, The Independent 22 May 1992

Notes

1. Apparently because Mitsui took a fright at Tricontinental’s loan portfolio.
2. based on the banks’ own annual reports.
3. See, for example, page 4 of the SBV 1990 Annual Report.
4. as noted in a report to Tricontinental from their auditors KPMG in 1988/89.
5. implicity.
6. Section 40, State Bank Act 1988.
7. thus going against RBA Prudential Statement G1 as the bank’s deposits are notionally jeopardised.