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THE name
of this weekly column accorded by the BusinessMirror to
the Financial Executives Institute of the Philippines
may need some rationalization in the face of the present
financial crisis affecting the whole world, because some
of the causes are blamed on the key factors that are
associated with “free enterprise.” President Bush has
put part of the blame on greed, and there is a subtle
dividing line between the profit motive that drives free
enterprise and greed. The issues of more government
intervention and regulation of the financial markets and
its participants are now urgent subjects, and “free
markets” are synonymous with free enterprise. In the
next sections of this article, we shall go over the
scenario of the current crisis and what lessons can be
inferred.
The
basics of banking and investment banking
THE
principal business of commercial and investment banks
are to act as financial intermediaries between the
sources and users of funds. Commercial banks take
retail and corporate deposits and lend these out as
loans and/or invest them in fixed-income securities. The
commercial banks make a spread between the cost of
deposits and other borrowings and the yield on their
loans and investments. That is the income that they
realize from providing depositary and cash-management
services and taking on the credit and market risks on
the loans and investments. Investment banks advise
corporate and institutional clients, including
governments and their agencies, how to access funds from
equity and bond markets. When they get the mandates from
their clients, they underwrite and sell their clients’
issuances of financial instruments through the stock and
fixed-income exchanges or through the syndicated loan
market, and charge their advisory and underwriting fees
and selling commissions.
Foreign-exchange transactions are also a staple source
of revenues of commercial and investment banks as they
facilitate trade and financial flows in a multicurrency
global economy.
The
traditional business of financial intermediation thus
looks quite straightforward. How did some of the
world’s biggest global commercial and investment banks
end up with over a trillion dollars of assets that were
subject to downward valuation adjustments?
Subprime
credits, structured notes and proprietary portfolio
AN
important part of the present financial crisis is seen
to stem from the fact that the big investment and
commercial banks have ended up with huge holdings of
structured assets in their portfolios. They have used
financial engineering and derivatives to create
high-yielding notes out of structures containing a mix
of financial assets ranging from the so-called subprime
housing loans to triple-A rated securities. Then they
had these notes and segments of these notes separately
rated by the rating agencies. These became the
collateralized debt obligations, credit linked notes and
other structures that were sold to institutional and
private clients who were supposed to be financially
sophisticated and able to appreciate the risks and the
potential returns of their investments. However, it
turned out that most of the big global investment banks
and some of the biggest US and European commercial banks
found themselves with very big investments in structured
investment vehicles. How did they end up with such huge
exposures that put their capital at risk in transactions
that are outside the traditional and commercial-banking
business? How did these huge risks get through their
vaunted and expensive risk-management tools and software
and risk-management officers?
There
will be volumes of papers and books on what happened and
what were the causes. I would like to suggest, however,
that the benchmark or fundamental issue to be raised is
whether the huge investments in what are now
“questionable assets” is within or outside the principal
lines of investment and commercial banking. The other
important question is, how did the risk-management
system managers and tools fail in preventing these banks
from taking on so much risk?
Corporate governance, risk management and credit ratings
EVEN as
the crisis has not ended with the bankruptcy of Lehman
and the bailout of American International Group (AIG),
government and corporate policymakers, as well as
research experts in banking and finance would need to
already start reexamining the paradigms of corporate
governance, risk management and the use of credit-rating
agencies. Going over the web site of Lehman, one will
see reassuring accolades in corporate governance and
awards and an upgrade in credit rating as recently as
June 2007. To cite a few examples:
§
2005:
Euromoney’s Best Investment Bank award, Standard &
Poor’s upgrade of Long Term Senior Debt to A+, citing
diversified earnings base and strong risk management.
§
2006:
No. 1 dealer in the London Stock Exchange in trading
volume. No. 1 in the “Barrons 500” annual survey of
corporate performance of the largest companies in the US
and Canada.
§
2007:
Fitch upgrade of senior unsecured notes in June “for its
strong financial results for the first two quarters of
2007 were a factor in the upgrade, as well as its strong
management capabilities and broad market presence.”
One will
probably read similar accolades in the web sites or
annual reports of Bear Stearns and AIG, and they would
all be true. This is precisely the reason for saying
that it is the paradigms that have to be reexamined
because the world’s biggest financial institutions have
been blindsided by the crystallization of a risk that
got through their risk-management models and systems,
and brings to question basic assumptions of risk ratings
and corporate governance.
The
system of the free market is still the best
IN spite
of the problems of the world’s financial markets
grounded on a free-market system, it is still much
better than any other system. While serious policy
adjustments may have to be made by both regulators and
corporations, the basic free-market mechanisms should be
the principal factors used for determining the
allocation of privately owned resources and investments.
Derivatives, credit ratings and risk-management systems
are very important tools in facilitating the efficient
allocation of economic resources. Former “command” and
centrally planned economies like China and Russia are so
much better now for adopting a free-market orientation
in spite of the ongoing crisis. |
