Corporate governance – Out number: the key to regulating against market failure

Two things are evident as the dust from the credit crunch settles. First, no one fully understood what the sheer volume of information available online (a volume available for the first time in a British recession) would do to financial stability. Second, regulating against market failure is terribly easy after a failure, but almost impossible when on the verge of one.

The impact of the increase in information available online has not featured anywhere on the regulatory radar. But in a recent lecture, Professor Avinash Persaud, chairman of the Warwick Commission on International Financial Reform and a member of the United Nations’ Commission of Experts on Financial Reform, suggests that as a result, we are all using the same models, herding like cattle around the same modus operandi.

We are concentrating exposure around the same risks – and rewards. Consequently, the pressure to do things at the margins increases, which ramps up risk. “Markets have become less diverse,” suggests Persaud, “and they follow the same rules, so when you sell, everyone else probably wants to sell as well.” We see illiquidity as a result, then the rating agencies start downgrading from AAA to AA.

We may not have fully understood that back when we were all having fun, but, as the Scots would say, ye ken the noo.

Persaud’s view is that much of the failure we have witnessed results not from poor risk controls – though they are also a culprit – but from the misunderstanding of the nature of risk and a fundamental problem with overconfidence in how easy it is to deal with risk. As he says, “Risk and liquidity are fluid things, not solid things, and they are determined by what people are doing with them. We have a misguided view of what risk is. Regulators thought it could be quantified.

“Risk has less and less to do with what the asset is. You can take a safe asset and turn it into something very unsafe.” Mortgages, for example.

He argues against the calls to suspend fair value amid the current crisis. “In the financial sector, [fair] value accounting should not be influenced by the fantasy of intentions,” Persaud says.

“Financial companies without the wherewithal to survive one day, are valuing assets on the basis that they intend to hold them for the next 20 years. But it should be influenced by the risk capacity of institutions and this risk capacity is most obviously and transparently reflected in the maturity of liabilities.

“From a financial stability point of view, those with short-term liabilities are risk traders and those with long-term liabilities are risk-absorbers. The system needs both. Through a host of measures, we have weeded out the risk absorbers, planted more risk traders and are now reaping what we sowed,” he adds.

It is not a comfortable analysis. From a corporate governance point of view, it makes everything harder. Boards of directors have to rethink their attitude to risk. “It is hard to see how you can make boards operate independently,” Persaud says. “They are captured by their executives. The risk committee has to hedge the company-wide risk.”

That could make people properly understand where the risk lies. Or possibly, boards would carry on ticking boxes instead. In any case, regulators, in his view, can never act in the middle of a boom. They can produce a bit of paper suggesting they had been warning of an impending crisis for ages. But as Persaud puts it, “Taking away the punchbowl just before the party gets underway is almost impossible.”

This means it is difficult to learn something new and specific from events. The Institute of Chartered Accountants of Scotland’s submission to the Financial Crisis Working Group, which makes a comprehensive, valiant effort to create understanding of the crisis, is a case in point. While firm in its view, much of it is forced by the ineptitude of regulators and bankers to be a statement of the bleedin’ obvious simply to get the most sensible points across.

Two things stand out. “First and foremost,” the submission says, “we do not believe that accounting has been a primary contributor to the financial crisis – it is a language that has attempted to explain the underlying economic reality. We do not believe that the accounting for off-balance sheet items or fair value accounting have contributed to the financial crisis – rather, it is the underlying structures and transactions, the risks attached to which were not fully understood or communicated, which were the source of the crisis.”

There is no arguing with that. The way risk has been misunderstood now seems like the biggest factor in the chaos that ensued. The second great misunderstanding is still not comprehended by regulators, or politicians for that matter – the red herring of deriving financial stability as a result of accounting.

“Financial stability is the responsibility of prudential regulators,” says ICAS’s submission. “The aim of financial reporting is to provide transparent information to users to assist them in assessing stewardship and in decision-making.”

Full stop, frankly.