Monday, 21 January 2013

Banks, Audits and Ratings

Most of the readers who are watching the current developments in economics and banking have surely seen the case of Deutsche Bank and Banca Monte dei Paschi di Siena SpA. For those who did not what the German bank did was to create a complex derivative which was able to hide all the losses its Italian counterpart had, with the latter placing a losing bet on Italy's government bonds (for further details, Bloomberg has an excellent article on the subject). 

The point to be made in this article is beyond the complex derivatives world where many of the sold products cannot be understood even by those who created them. It is about the role of banks in modern societies and the much more important role of auditors and rating agencies who supposedly examine these accounts thoroughly to provide investors with their opinion on the subject.

Auditors have long been in my mind (or maybe in everyone's mind) as the people who oversee whether a company is doing it's job correctly in informing investors and the general public over its financial position and the dangers it might face in the future. Yet, as many have stated over time, there seems to be a great conflict of interest: auditing firms get paid by the people whom they audit. So the situation presented to them is similar to the following example: company X is paying you a substantial amount of money every year to tell everyone else in the world if its practices are correct and whether they should be fine in investing with it. Yet, if investors do not put their money with company X as a result of your operations, then the company will seek another auditor and you will not get any money. Morally there should be no problem: you do your work and be honest on whether the company has a solid financial position or not. Yet, as most things in real life, it is not just black or white. What happens if that company is very large, probably your best client, have a long professional relationship with it and is one of the major sources of income for you? If you disclose the truth you lose a very large income which you were most likely going to have for the rest of that company's life. If you do not then you may face consequences. Not so easy is it?
The accounting cycle. Source: Wikimedia Commons. Author: Club-oracle
Yet, it should be. Remember the failed energy giant Enron? Well Arthur Andersen, the firm who performed the audits for Enron was shut down after the scandal. What is more, the Andersen's auditors were not even allowed to work in the industry again. Now do tell me if that happened every time when auditors did their work bad, how many auditors would we have? Either very few behaving well or many behaving well. Given the workings of the supply and demand forces I think the latter is much more probable than the former. Yet, as people do not get punished for their wrongdoings much of this is continued. Had the auditors who reviewed the Greek banks' accounts in 2008-2009 posed any thoughts on the quality of their loans or their financial positions? How about Spanish, Italian or Cypriot banks? Had the auditors done their job correctly in Germany or not? 

One may argue that the banks' financial accounts are more complex than any other company's. Maybe that is so. Yet, as the student's expertise rises should the examiner's expertise rise as well? If these people are not really experts in their fields (i.e. bank auditing) what business do they have reviewing balance sheets?

A similar point of view arises when one looks at the ratings agencies. Over the past few years many have questioned both the legitimacy and the trust people should have on ratings agencies (for a detailed post on the subject I refer you to Protesilaos's post here). Yet, nations and individual companies watch them eagerly as the opinion of Moody's, Fitch, and Standard&Poor's shapes the markets in most (if not all) countries of the world. They are considered independent and yet their source of income is derived mainly through the same channels as the auditors: the company who wishes the agency to rate a product (or the whole company) pays them a significant fee to do so.

Although many might argue that they are indeed honest with their prediction on sovereign nations over the past couple of years (at least in Europe) I would remind the reader of the sub-prime debt fiasco. While these collateralized products should have been graded as poor investments they had been awarded an AAA status, the highest obtainable in their scales. Maybe they could not have seen what would happen. Or maybe knowing that if they impose harsh ratings they would be losing clients to the other two each decided to be lenient with their ratings. Very lenient if you consider the chaos that occurred in 2008...

What can we do about this then? Should we use more and more experts to oversee that banks are doing their best not to "cheat" investors? Should we impose stricter rules on auditors and rating agencies and the problem will immediately be solved? The answer is actually much simpler than most people believe: regulations which would forbid banking institutions from using derivatives other than for currency and interest rate hedging (the reason is that currency hedging has good reasoning behind it as it protects the bank from severe changes in the exchange rates. Similarly for the interest rate hedging) would solve the problem much better and much faster than anything else. If banks are not allowed to invest in complex derivatives or buy loans from other banks then this would both make the banks' and the auditors' work easier. In addition it would have the advantage of the banks being less prone to bubbles and busts. Which would mean that less government support (i.e. tax-payers money) will be needed to bail them out.

What should happen is that banking institutions should be completely independent of all investing activities other than the ones described above. The banking industry should make a return to the traditional commercial bank model instead of the do-it-all one it is currently practicing. Sure, profits will be reduced. Still the world would be a much better place. Banks have outgrown most of their home nations. Even in Germany, Deutsche Bank's assets are about 2/3 of the German GDP. You may only imagine what happens when other banks are added. Deutsche was one of the main orchestrators of the 2008 financial crisis by issuing tremendous amounts of collateralized debt obligations and selling them to investors. It is claimed that they have failed to acknowledge a up to $12bn of paper losses in their $130 billion portfolio of leveraged trades. You may imagine the assistance needed when if this bank ever needs assistance. Yet no actions of forbidding it from trading and forcing it to stick to its commercial activities has been taken...

We can only safeguard ourselves and our banks by making them less prone to collapse. That can be easily made by forbidding them to engage in investing activities, imposing harsher penalties to misbehaving auditors and ratings agencies. Still, nothing has been done. Let's hope that legislators decide to take some action and refrain from the "this time it's different" notions...

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