John Plender: Black holes in global finance By John Plender
Financial Times Published: April 10 2005 20:15
Complexity, opacity and the woes of AIG
The departure of Hank Greenberg from American International Group while the regulatory authorities investigate the US insurer's wayward accountancy habits leaves me wondering whether the world's financial services groups are too complex and opaque to be properly accountable to anyone. Equally worrying is that the number and size of the black holes in the financial system appears to be increasing by the day.
Take the burgeoning derivatives market. Of the $88,000bn (£47,000bn) notional value of derivatives at US-insured commercial banks at the end of 2004, according to the latest data from the US Comptroller of the Currency, no less than 93 per cent was traded in the non-transparent over-the-counter market in which banks trade directly with each other. Five banks account for 96 per cent of the $88,000bn. Most of their shareholders, I suspect, have little grasp of the risks involved.
Then there are the hedge funds who, as we all know, are among the fastest growing, least informative and least regulated members of the global financial community. Some central bankers argue that the growth of credit derivatives helps reduce systemic risk because credit risk is being transferred outside the banking system. Yet the lesson of the Long-Term Capital Management débacle was that hedge funds have a symbiotic relationship with the banking sector.
Interesting to note that a new academic paper by Nicholas Chan, Mila Getmansky, Shane Haas and Andrew Lo suggests that the hedge fund industry may be heading into a period of lower expected returns and that systemic risk is now on the rise.*
Note, too, that regulation may be adding to opacity. For while Pillar III of the new Basel capital adequacy regime is meant to enhance transparency, many fear that it will produce a welter of confusing non-comparable data. At the London School of Economics last week Jaime Caruana, chairman of the Basel Committee, put a powerful case for the Basel framework. Yet he wryly admitted that while everyone wanted simplicity, all who lobbied the Basel Committee asked for solutions to their problems that would increase the regime's complexity.
So we have a paradox. More risk is being priced in markets today than ever before, which should make for a more efficient financial system. Yet much of this market activity is untransparent, which is worrying for financial stability. A consequence is that in the financial sector shareholders are more than usually dependent on the competence and integrity of executives, auditors and non-executive directors to monitor and manage risk. But at least corporate governance is not complex.
A governance-aware shareholder looking at AIG would have noted classic governance warning signals: an over-dominant chief executive, a suspicious number of related party transactions and fishily consistent increases in earnings. The trouble is that when share prices rise consistently, few pay much attention to corporate governance.
- Systemic Risk and Hedge Funds, NBER Working Paper No 11200.
Pensions and bond bulls
British companies with big pension deficits will not be comforted by the Pension Protection Fund's new guidance for valuing protected pension liabilities. Some had hoped the PPF would opt for the actuarial approach whereby liabilities are discounted at an interest rate equivalent to the expected return on assets. This incorporates the Alice in Wonderland assumption that you can shrink liabilities by investing in riskier assets.
Instead the PPF has gone for a government bond discount rate. As pensions consultant John Ralfe noted in a recent analysis of the PPF for RBC Capital Markets, it is not clear how the PPF value of protected liabilities will work with the Pensions Act's do-it-yourself statutory funding objective and how companies will be forced to make up shortfalls against the PPF value over set periods. But it does look as though we now have a new and different version of the unlamented minimum funding requirement.
An important implication is that trustees who are expecting to meet the statutory funding objective using the expected return on assets basis of valuation will be put on the spot. They will have to explain why they consider it prudent to fund on a weaker basis than the PPF. It looks like a victory for the pension fund bond bulls, among them John Shuttleworth of PwC, whose untimely death last weekend deprived the pensions business of one of its wittiest and most pungent commentators.
Towering greed
There is one group of people that will be eternally grateful to John Towers and the Phoenix gang who pocketed tens of millions while presiding over MG Rover's demise - the folk who run ethics courses at universities and business schools. This is the ultimate case study in greed and a missing shame gene. Thank you, Mr Towers.
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