A soft introduction to a hard landing of our financial system.
By Jules Muis, Former VO & Controller of the World Bank.
In common parlance, ‘micro-managing’ does not have a particularly heartwarming ring. It connotes decisions being made by bean counters at the expense of the bean makers. It sounds, in particular, un-sexy when put to those high-flyers among us who see it as their job to comfortably float 30.000 feet above the economic landscape.
A soft introduction to a hard landing of our financial system
I witnessed this phenomenon first hand some ten years ago in the slow-motion, tedious, surprise (re)discovery process of World Bank economists during the Latin American and East-Asian crises. At that time we saw whole economies overturned by the tsunami effect of poor corporate accounting in combination with lax, unaccountable corporate or institutional governance principles. In the wake of the havoc that followed the world and grudgingly the world of high-flyers accepted that good corporate and public sector governance, and processes as low in the occupational food chain as financial accounting, properly belong to the exclusive club of economic fundamentals. At least, it was conceded, they were preconditions for economic fundamentals to work. To my mind, it simply confirmed the age old adage that the quality of the whole is as good as the quality of its parts; and vice versa. That is, systemic macro-control concepts are not just empty baggage in academic discourse. They have their own real-world DNA.
Hence, at the turn of the 21st Century, we sternly lectured developing countries in the newfound good governance scripture. The lecturing continued until Enron and the dot.com crises signaled a new wake up call and reminded us that the cumulative effect of sound micro-housekeeping habits is not just of importance to fragile or emerging economies but has its own universal application.
The sub-prime burning platform
The present sub-prime and financial systems crises reprise these past experiences beautifully and unsettlingly at the same time. With the seizure in liquidity and financial systems tightly wrapped around crises of confidence among banks in each other’s balance sheets – the image of a burning off-shore drilling platform comes to mind.
Angst is still unfolding as I write, offering us a challenging opportunity to re-examine our latest found articles of belief. Particularly troubling is the question of whether we ever truly learn anything from the past. One might reasonably wonder whether we do ever learn, especially when the present context is held hostage by the age-old lures of the quick buck, propelled by the money pushing departments of our institutional money machines that make things happen, for better and worse. Can there be macro management instruments available for our lofty macro managers to assure orderly processes—and even if so—can they really influence and control the freedom of movement of too savvy or shrewd financial industry players.
I will address that question by a quick scan – top down – and by a selective risk assessment of the macro checks and balances. I will be focusing on the weakest links in the accountability chain, using the common-sense principles embedded in risk management widely applied at the micro level, but for one reason or another not catching on with our macro managers. I start from the general value judgment that unless we address the necessary fixes in our macro architecture, duly borrowed from micro risk management experience, self-inflicted macro financial crises will assuredly continue to repeat themselves. The fix will prove to be, for most part, motherhood and apple pie, and political wills willing. But are they?
The present financial crisis was predictable, has been predicted – indeed, I did so myself by co-authoring/publishing a ‘survival kit for accountants and auditors in a turbo derivative environment’ in the fall of 2005. We may have a global economy, we may have a global market, but we do not have global institutional ownership, steering mechanisms…hence accountability…based on a willing understanding of all the vital parts. ‘Let all flowers bloom” has been the operating principle of our fragmented overseers of financial stability.
Thus, moving forward, a not overly intrusive dose of micro risk-management inspired cold water might come in handy. Let’s give it a try.
Ownership/the governance of governance
As I see it, we have no credible robust international financial architecture that establishes a macro accountability construct with clear ownership for material upheavals in the financial markets, nationally and internationally. The Financial Stability Forum (FSF) set up in the wake of the East Asian crises to see generally what it did not see in particular is, by its very own feeble coordinating and inventorying nature, establishing at best a debating club rather than, as advertised upon its inception, a financial fragility systemic assurance results-focused organization. The FSF has morphed into a global political think and talk tank, not a ‘do’ tank. Its reporting/accountability syntax is open-ended and open to interpretation. Most importantly the FSF will not give, and it is not expected to give, reasonable assurance as to “the absence of weaknesses in the architecture and/or its workings, that may form a material threat to the financial markets”.
Together with the politeness conspiracy- hampering a frank exchange of non-discussibles (see my discussion in the previous issue of Public Risk Forum), the FSF modus operandi adds up to a recipe for allowing slippery slopes to be built on top of slippery slopes without anyone noticing. The FSF’s very own architecture is simply too fragile to carry responsibility for the world’s financial architecture. Hence, it doesn’t–which turns its effective existence into a dangerous illusion that we have a global financial system gatekeeper. My proposal would be to at least force out in the open the limited comfort, if any, the FSF is able to give, by requiring a reporting syntax that makes clear not only the systemic risks as it sees it, but in particular also the unknowns in its operating equation.
This observation leads us to also note the absence of proper accountability constructs of all oversight bodies in our economies (regulators and compliance enforcement agencies themselves, national and international) as a precondition for the FSF to work. None are expected to do so, hence none do, in the context of their systemic remit, leaving an ever more interdependent financial system too much in the dark about the unknowns in the financial fragility equation, or even the most important impending risks. The reporting structure of our oversight bodies, including accounting and auditing bodies, is one of a new algebra that suggests one can ignore, or worse, that it does not account for unknowns in the financial system equation. The present construct does allow for plenty of politicized, occasionally useful, piecemeal expressions of selective comfort or discomfort; but lacks a results-based reporting syntax. This is too fluffy for anyone’s comfort, as we now see. At this moment corporate managements and their auditors, through SOX and the like, at the micro level, are the only actors expected to frame their assurances in an unequivocal reporting syntax. It is time to elevate this useful micro-world reporting syntax to our macro managers few macro layers up, for all our comfort.
Exotic financial products
We have painfully discovered over time that there is no substitute for getting things right at entry level. ‘Garbage in garbage out’ is a must in any management consultant’s power point presentation. Yet we have allowed the development of financial products/derivatives, useful as they may be in unraveling and re-bundling of risk profiles, to evolve such that the even the mathematical finance specialists, buyers, and sellers of these products can be bewildered by them. In my view we have difficulties acknowledging that because there is money to be made through black boxes.
Alan Greenspan, the past Chairman of the US Federal Reserve, was allergic to regulating these markets, the assumption being that the markets would be self-cleansing. We have now come to discover that such belief—needless to say—is naïve. Indeed, such is that case that in mid-September 2007 market players are all anxiously waiting for the financial reporting shoe of key financial players to drop; and to see whether the assumed global risk spreading potential of derivatives has lived up to its professed potential. Central banks in the meantime are the lenders in last resort and serving as the last defense line before a run on our banking system by the banks themselves.
I first made a proposal some ten years ago, to limit trading in derivatives to those “dog-tagged” with a bar code reflecting the risk profile of the product in a universal risk language and it may be time to think about this idea again.
Exotic accounting of exotic financial products
Against this background of mushrooming creativity in the language of financial markets, accounting standard-setters and accountants have great difficulties keeping up translating these financial products into unequivocal accounting, the language of business. Not only are they confronted with the need of capturing economic substance over form of complex products expressed in legal language, but also they need to capture the purpose and intent of bundled transactions or embedded derivatives in all combinations and permutations possible. The accounting profession was and has been losing its breath in keeping up with both terminology and the nature of the mutating products themselves. Moreover, financial reporting is predicated on the intricacies of the micro-world, and not geared to the question whether it all adds up for the macro (i.e. to establish the macro effect of by definition zero sum transactions, such as swaps). Such leeway can lead to systemic distortions/ earnings mismatches by having counterparties with different income recognition/timing practices. We do not have double entry bookkeeping at the macro level for the same transactions, hence do not have a monitoring mechanism that watches for bubbles in the cumulative E, of the P/E equation.
This would in particular become a concern if there were orchestrated efforts to capitalize on such loopholes. But it has happened before that companies exchanged financial products- without exchanging risks – purely for the convenience of the income management of one of them. With black box entities, such as hedge funds or conduits being exempted from public financial reporting, and mushrooming in our macro-economic equation, and with the ever increasing creativity in off-balance sheet financing, it will be interesting to see the coming couple of months whether my concerns are warranted.
My bet is that we will draw lessons from this all, independent of whether we will experience a soft or hard landing. I would see regulation changes to the effect that the key to public reporting requirements of an economic actor should not be not its legal but its economic status, individually or collectively, as a relevant variable in the macro-economic equation. Stress testing financial fragility by experience rather than by foresight will be seen as too reckless a proposition.
Whatever the outcome of the present crises, the coming couple of months are going to be eye-openers for those keen to see robust macro-risk management of the fragility of our financial systems. I find it hard to fathom that we will not see important lessons being drawn from the present deep freeze in credit. Our micro risk management toolkits have a wealth to offer in seeking solutions. Remember that there is little standing between the lenders of last resort and our economy as a whole. So reason to hope that the penny will drop that when top down macro risk management fails, time has come for bottom up, micro-inspiration, in seeking solutions; and ‘micro-managing’ may lose some of its bad name.
If the present construct is no a way to run a railroad, it certainly falls short of running our financial systems.