RSA shows high returns always come with high risks

The explanation for why things went so badly wrong at RSA in Ireland is not contained in the statement released by the company in Friday. It details "inappropriate collaboration" by senior managers in Ireland to circumvent controls and present a misleading impression of the Irish business to the group.

That maybe the the how, but it is certainly not the why. The statement does not explain why five years after an existential crisis in the global financial services industry this sort of thing can happen. In spite of the UK and British regulatory regimes being overhauled and the upper echelons of RSA having had ample time to learn the lessons of the crisis, along with pretty much every other financial services business, it remains prone to this sort of catastrophe. The why is actually contained in a statement released last December by RSA when the problems in Ireland first came to light. “We now expect mid-single digit Group return on equity in 2013,” it told the market. Prior to the problems in Ireland, RSA had been predicting a return on equity of 10 to 12 per cent.

Return on equity (ROE) is one of the metrics by which company performance is assessed. It is one that allows investors decide whether or not they should invest in a company or if they would be better off putting their money somewhere else, such as a deposit account.

However, it can’t or should not be used in isolation. Returns are always a function of risk. It follows that investors should be prepared to accept a lower return for lower risk. This explains the appeal of low yielding sovereign debt which offers a very low return.

People investing in RSA – which paradoxically includes numerous other insurance companies – should not be expecting double-digit ROE from a company on which people rely on to pay their pensions and meet their insurance claims. It should be safe and boring and investors should attach a value to as well.

Competitors
The opposite seems to be the case. RSA – like its competitors – was promising a double-digit ROE and investors appear to have been expecting it. If your accept the premise of one of the better business books of last year, The Bankers' New Clothes by Anat Admati and Martin Hellwig, this mismatch between what a financial institution does, and the profits its expected to achieve, is the ultimate explanation for what went wrong at RSA Ireland .

They argue that the expectation of such return and the desire of management to deliver them – and reap the rewards – is the cause of the ongoing dysfunction and fragility of the financial system. The problem came home to roost with catastrophic consequences in 2007 and will again. The problem is that there are only a limited number of ways in which banks and insurance companies can consistently deliver such returns; all of them are dangerous.

The biggest and most lethal is leverage. The more borrowed money you use to fund lending and trading , the less equity you use and the bigger the return you make on equity. Leverage was the reason that the impact of the financial crash was so contagious. Leveraged financial institutions chasing high returns did not have enough equity to absorb their losses and collapsed, triggering losses at other banks.

Regulators have pushed financial institutions to carry more equity to absorb losses since 2007. They have been fought tooth and nail by the industry who have emphasised the short term impact in terms of profits, growth, jobs and the like. By and large these arguments have trumped the longer-term argument that as long as financial institutions operate in this fashion the risk of losses, collapses and maybe even another systemic crisis remains high.These are usually borne by taxpayers.

Status quo
As long as the status quo remains the management of companies such as RSA are under pressure – and incentivised – to knock double-digit ROE out of a business that if prudently managed should be expected to return single-digit ROE. The temptation to cut corners and massage the numbers are immense. If the directors of RSA wonder what possessed the Irish management to do what they are alleged to have done – and why the UK management didn't seem to notice or question the results – they should start by reading Admati and Hellwig's book.