Chief UK charity lender defends its approach to falling bond values

The Charities Aid Foundation is one of the UK’s most successful intermediaries.

It was founded almost a hundred years ago as part of National Council of Social Service in order to encourage charitable giving. In 1974, it became an independent organization and acts as a conduit for tax-efficient donations to charities from businesses and philanthropists.

The foundation is now the UK’s biggest charity in terms of income. Donations range from paying payroll to buying high-end property, antique carriages, and art. According to its website, it distributed more than £1bn in grants to 160,000 non profit organisations worldwide and worked with 55% of FTSE100 companies during its last financial year.

This institution has been in the spotlight this week after it announced Monday that it would give £15mn as “additional assurance” to its subsidiary CAF Bank which had reported significant losses on its bonds portfolio. The bank is used by more than 14,000 charities.

CAF Bank, founded in 1984, generates profits for its 99-year old foundation. It also helps to support the owner’s mission by providing bank accounts and loans.

In an interview, Alison Taylor, CAF Bank’s chief executive said that this “mixed motivation” rather than a focus on maximising profits means “we can incredibly conservative with our balance sheet management and that’s exactly what we do”.

In its annual report, released last week, the bank revealed that the value of its bonds was £33.4mn less than their book value on April 30. This is equivalent to almost three quarters of the regulatory capital of £45.1mn. This paper loss was not recorded in the lender’s accounts as it intended to hold bonds until maturity.

It would only be possible to realize the unrealised loss if they sold their bonds too early, which is what could happen during a liquidity crisis. If the bank is forced to accept a loss, it will lower its capital ratio to risk-weighted asset below the minimum regulatory requirement of 14 percent.

CAF Bank said the loss was only “theoretical”, because it was unlikely that they would need to sell their investments before the maturity date.

After nearly 15 years of ultra low rates, banks must now pay attention to the risks that rising rates pose to their balance sheet. In order to reduce their risk, banks use hedging instruments like swaps in order to protect themselves from rapid rate changes.

The Bank of England carefully monitors interest rate risks. In its most recent annual stress test for the UK banking industry, published last month by the Bank of England, the bank found that lenders that it regulates had made losses on paper of approximately £19bn in the market value on securities that they held. However, the majority of these losses were due to currency movements on foreign investments.

The CAF Bank’s disclosure of its mark-to-market losses on the bonds is similar to the problems that brought California lender Silicon Valley Bank down in March, although on a smaller scale.

SVB invested heavily in bonds that paid a fixed rate of return. Its customers were mostly start-up tech companies. As interest rates increased rapidly, the bonds’ value decreased, leaving SVB with a precarious position. Customers began withdrawing their deposits, and SVB was unable to raise new capital.

Taylor denied any comparison to SVB. She said, “My understanding was that they had a much lower level of liquid cash before they started selling their bonds and therefore began crystallising losses.” This is a completely different balance sheet to ours. “It’s not a problem at all for us.”

SVB had not implemented enough hedging and, unlike CAF Bank’s bonds, they were not held until maturity.

CAF Bank has no financial instruments to hedge their investments, despite disclosing a value of £17.4mn below the book value of its bonds at the end April 2022.

Taylor stated that her bank had considered its hedging strategy as interest rates changed. “But at the end, the fundamental principle remains the same: we always have and always will hold to maturity.” We never trade so this unrealised mark to market is not an issue.

CAF Bank announced this week that the Foundation had agreed to contribute £15mn. This, combined with the existing capital surplus of the bank would cover the loss in the event it was forced to realize it.

The bank stated that it didn’t need capital, and that its new funding would be structured in the form of subordinated debt. This would only count towards capital requirements if regulatory approvals were granted at a future date.

Taylor stated that CAF Bank could continue to operate even without additional funding from its owner: “We didn’t and don’t need this funding.” We had and still have a significant capital surplus.”

According to the CAF Bank’s annual report, liquidity stress tests have shown that CAF Bank is “able to survive a withdrawal of deposits in excess of 77 percent of its balances”.

CAF Bank holds more than a third of its £1.5bn of deposits in cash on the Bank of England Reserve Account, which is a much higher percentage than any other commercially-focused bank. A large part of the CAF Bank’s £1.5bn in customer deposits is held as cash on its Bank of England reserve account, a much higher proportion than a typical commercially focused bank.

Taylor stated that the charity loans totaled £178mn. The loans were backed by assets and made with a “very cautious” approach, limiting loan-to value ratios.

Customers have not been alarmed by the unrealized losses. Charity groups confirmed that they did not receive a flood of inquiries, but noted that many of their members do not use CAF Bank.

Nick Sladden is the partner and head for charities at RSM. He said that he received very few inquiries from clients about this situation. This indicates that charities do not appear to be concerned.

He said that after the bank disclosed the unrealised losses it was best for trustees of charities to assess the risk and document their assessment.

CAF Bank said that about three quarters of its customers had deposits below the maximum compensation of £85,000 available under the Financial Services Compensation scheme, which protects eligible account holders’ deposits in the event of a UK bank failure.

Taylor stated that the bank has seen net inflows as of Tuesday afternoon since Friday when it first reported the losses on bonds. The bank also has not received a flood of calls from account holders concerned. Taylor said that the bank has received fewer calls and emails from customers than usual.