Joao Brandao
Word count: 1995 / PIN: 10521
Joao Brandao
The financial industry – From Hawaii to somewhere else. 1. Current crisis’ facts Statements of companies losing the bulk of their market capitalization in an extremely short period of time seem commonplace to nowadays news readers. Nevertheless, a more careful analysis shows how astonishing it actually is. Market Capitalization indicates the current value of a company, as perceived by investors – who, if not rational, are supposed to act at least reasonably. A loss of 90% of a company market capitalization, within a couple of months indicates that, in this short period of time, investors revised the value of this company to a tenth - including its contracts, physical assets, know-how, brand image, work force, organizational culture and history in the society. What can be said about fundamentals? Is there a minimal stability on valuations that would justify its existence as a measure? Since the last quarter of 2007, the financial world experiences a shake-down in all its previous certainties. Current scenario comprises unforeseen wide corporate debt spreads, equity markets down to approximately a half worldwide, huge losses for pension funds, banks bail-outs, a dramatic shrink in alternative investments’ assets and concept attractiveness, real estate prices plunging and cheap bargains waiting for a good soul to pack them home. But what does all this mean? In there any truth or human sensation behind expressions such as widening spreads, equities downturn, bail-outs or shrink in alternative investments? Where is the connection between the financial fiction and individuals’ daily realities? 2. Some reasons The facts mentioned in the first section, summarizing current markets’ state of affairs have certainly a great variety of sources. There is no packaged explanation for a global turmoil of such magnitude. An analytical effort makes sense, though. I believe that the analysis can be made in two abstraction levels: i) the first, more factual, towards which specific actions can be undertaken to favor the emergence of a healthier environment; and ii) a more generic one, based on cultural aspects, whose directions are determined solely by the conjunction of several factors. 2.1. First abstraction level In the first abstraction level, two explanations can be put forward. One concerns the structure of information management and the other refers to a mixture of excessive risk-taking and lack of transparency. 2.1.1. Structure of information management The portfolio diversification principle implies holding a stake in different companies or assets in order to minimize risk exposure and to increase the remuneration per unit of risk of the overall portfolio. Holding a diversified portfolio means as well that the portfolio manager needs to monitor the evolution of a range of securities from which he may never had heard or seen, besides the numbers in his excel sheets. A “VlookUp” function providing the hopefully accurate accounting data and consequent financial multiples is all he may have at his disposition. The competition between asset managers pressures their cost structures, what culminates in one portfolio manager being responsible for an enormous number of accounts, especially in the case of private banks’ mandates. Nevertheless, this is an optimistic case, since there is still a manager taking care of the investments. Several quantitative investment strategies are controlled by a pre-defined
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Joao Brandao
algorithm which incurs trades based on econometric measures. No relation to real company management. No worries on the actual facts behind the variables’ Greek letters. 2.1.2. Excessive risk-taking The second factor relates to the excessive risk-bearing and the lack of transparency which dominate financial markets. Excessive risk-bearing is to be seen everywhere, from “dynamic” money market funds to highly leveraged structures, passing through ad infinitum securitization. The attempt to enhance performance, despite the price implicitly paid, is the main driver of this scenario. When looking at the structure of financial markets, what astonishes the most is the accordance of regulators and institutional investors with accounting and risk-measures practices delivering a clearly irresponsible message. Two simple examples: Earnings per Share measure and Off-balance sheet accounts. The first is a measure of a company’s profitability. It is calculated by dividing net earnings by the number of a firm’s outstanding shares. No problem if it would not be an easily distortable index and if its usage would not boost risk-taking as an overall practice to increase share price. Taking more debt relatively to equity, what means leveraging the company’s capital structure, reduces the number of shares against the potential profit that the overall capital can generate, increasing earnings per share. The sensitive point is that the risk one shareholder faces by holding one share of a highly leveraged company (possibly with higher Earnings per share) is not comparable to the risk he faces by holding one share of a operationally similar 100%-equity company. The focus on earnings per share is, consequently, a misleading practice since it totally ignores the amount of risk undertaken in order to generate a certain amount of return. The second example concerns the off-balance sheet structures. The function of the balance sheet is to provide a global view of the company’s patrimonial structure. It is supposed to inform in a systematic way about its liquidity and solvency scenario, as well as about its ratio of investments in fixed assets to working capital. The same applies to banks and financial institutions. Even if banks’ balance sheet refers to operations of a different nature, the fact that it should be an overall trustful guide to conscious decisions remains unchanged. Why then allowing off-balance sheet structures? Practioners tend to say it is a way of limiting the effects of prices’ volatility on banks’ balance sheets, which would be too heavily affected by the mark-to-market system. One question remains: shouldn’t the problem rely more on the fact that balance sheets are to a very high extent comprised by too risky assets? Wouldn’t a limitation of the degree to which banks can hold potential toxic assets make more sense than creating off-balance sheet structures? These are reflections that come to play, unfortunately, a little late. 2.2. Second abstraction level 2.2.1. Disconnection between the financial world and people’s daily realities A more profound look into the facts and behaviors described above generates the question of how all that influences daily life and what is the reason to worry about it. The somehow scary financial dictionary – with cold words and often pseudo-smart metaphors gives economic facts a sense of science fiction, making people forget these facts have direct consequences into their destinies. Exactly there, at the disconnection between the individual behavior in the “financial world” and its consequences in the real life, resides one possible explanation for the excessive risk-bearing as well as for the disregarded mechanism of information management described before. New technologies in the form of data provider services, instant trading systems and advanced quantitative models strengthen the segregation between the reality in which the
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investment is effectively made (the ideas and structure in which the money will be used) and the reality where the portfolio manager presses the Enter button. On the other side, the reality where the investor reserves part of its remuneration or accumulated savings in order to assign a mandate for a third party to manage it is also completed apart from that of the person who will effectively manage it. The intermediary function of the financial markets – establishing the connection between people who have money but no profitable business and those who have profitable ideas but no money – isolates the financial reality from that in which real people generate richness. Consequently, both the interpersonal relations – client vs. manager and manager vs. investment receptor – do not “feel” real. For the manager, his relation with clients takes the form of graphs and tables in the sales’ review meeting, in which the evolution of its penetration into the distribution networks is monitored. On the other side, his relation with target investment receptors appears as spreads/stock price movements, reflecting changes in demand or supply for the specific security. In addition to that, the manager’s relation with people’s savings gains a different color as well. The sanction for losing people’s money comes in the form of the threat of losing his job, or the threat of having his fund cut-off. Unless the specific manager is the only one (or one among a limited number of managers) that performs poorly, he does not suffer a high penalty. When the whole industry does badly, the responsibility for the downturn seems diffuse and there is no easy target to which investors can address their complaints. In this context, managers are offered a protection in case of downturn, while being able to enjoy the advantages of the upsides. 2.2.2. The dominance of one cultural model The financial markets are very much influenced by the Anglo-Saxon cultural model. This is true for many features of today’s world, but the financial sector reveals an especially higher prevalence of a single-modeled cultural influence. First of all, it is important to state that the association made between the financial markets’ features and the Anglo-Saxon culture is to be analyzed in an objective way. It means that no responsibility for the development of financial markets in the last years should be solely attributed to English ad North American, nor that the responsibility for the recent downturn is to be fully accounted to them. No value consideration is to be put forward. The idea is to approximate this analysis as much as possible of a scientific approach. North American, as stated in their famous expression “America is the land of opportunities” use to be entrepreneurial people, who feel individually responsible for their own future and success. In this sense, culturally speaking, it is common that they rely less on the local communities or on their federal government for providing them public goods or for granting them an enjoyable life standard. These responsibilities are in a very great extent imputable to their own actions. This cultural aspect brought to life a very entrepreneurial approach, what often includes a high degree of innovation, risk-taking and private autonomy in the marketplace. In this sense, the evolution of financial markets shows a case of dominance of one cultural model as one can rarely see in other sectors of society. Apart from general features related to the industry shape itself (such as those stated before: innovation and risk-taking), other aspects of cultural prevalence can be seen as well in basic and not easily noticeable practices. The sense of humor of people involved in this industry, as well as the way of presenting their arguments are much more harmonized under the American model than one can imagine. North American and English tend to be very direct and objective when presenting their arguments, using commonly an inductive approach. This
Bliss or Misery? Contemplating the Engagement of Cultural Forms and Economic Progress
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Joao Brandao
means that the analysis is often less profound, more concise and it departures from the conclusion, to, afterwards, present what has driven them. 3. Opportunities Today’s society is living a precious moment in which much change can be done. The financial crisis, which disrupted into an economic, regulatory and political crisis, gave us the possibility of rethinking and re-shapening future institutions. Not only more attention is to be paid into the level of risk taken by individuals and asset managers, but also a much broader transformation can be expected. This transformation may include growing attractiveness of socially responsible investments, which take into account environmental, social and corporate governance issues. Apart of that, the current situation certainly affected the image and the credibility of today’s financial industry’s model. This offers the possibility of new models emerging in different geographic areas, such as China or Brazil. So, if the financial industry used to be Hawaii, in the sense of its Americanism (dominance of a specific cultural model) and of its insulated character (due to the depersonalization of the relationships between managers and investors and managers and investment receptors), we expect it to be somewhere else in the future. The more inclusive, diverse and ethic it gets to be, the greater the benefits that the society can obtain from its functions.
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