Dear,
One of the main concerns after 2008 Financial Crisis is improving transparency on the Financial Markets, and some general consensus has been achieved about the necessity of building a more stringent regulatory framework for the financial system, capable of increasing transparency and stability.
The current regulation, particularly the accounting standards, gives many opportunities for hiding the real situation of a financial institution. There’re many ways of hiding information which can compromise markets opinion about the financial stability of an organization, let me name some well-known examples.
- Massive use of Off-Balance contracts for hiding debt.
http://www.investopedia.com/articles/analyst/022002.asp
- Securitization of high risk loans for hiding counterparty risk.
http://www.investopedia.com/articles/07/subprime-overview.asp
All Financial Crisis have in common that require a bubble to be inflated and burst; but while the bubble is inflated, a hiding mechanism is required to hide the bubble to potential investors.
Obviously, if investors knew that an asset is inflated they wouldn't invest and the bubble could not be inflated. Off-balance accounting postings, assets securitization, Repo 105, OTC Derivatives, have been traditionally accepted and legal accounting practices used as bubbles hiding mechanisms.
In my opinion, the main consequence of this Financial Crisis is moving from a Financial System based in Volume to a Financial System based in efficient management of solvency and liquidity. After this systemic change, growing by inflating and bursting bubbles will not be an option.
Consequently; hiding mechanisms, necessary for inflating bubbles, will not be tolerated.
Every bubble, and the current debt one is a very good example, requires confusing solvency and liquidity. Liquidity increases temporarily the value of an asset, solvency makes the value of the asset long-term sustainable.
http://sapbank.blogspot.co.uk/2013/03/why-do-they-call-it-love-when-they-mean.html
But preventing hiding mechanisms requires more than adjusting the accounting standards, new mechanisms of financial reconciliation are going to be required.
Simplifying, every Financial Asset has a value which depends on a promise of generating future cash-flows and the probability (risk) that those “agreed” cash-flows are successfully delivered.
We work on two main families of valuations; mark to market and mark to model. The first one assumes that the market has perfect information about the value of the asset, the second is build on the hypothesis that the Financial Institution has all the information about the probability of getting successfully the promised cash-flows.
Unfortunately, as the multiple bubbles have made clear, both approaches are incomplete. Injecting or drying liquidity in the Financial System increases and reduces the value of the assets, without any real estimation of its long-term sustainable cash-flows generation capacity; and mark to model estimations have many holes for executives hiding the long-term sustainable value of their assets (Repo 105, Securitization, Off-balance accounting, etc.).
We need a new concept, capable of disclosing the long-term sustainable value of the financial assets.
But this post has become too long, we'll talk about it next week.
Looking forward to read your opinions.
K. Regards,
Ferran.
One of the main concerns after 2008 Financial Crisis is improving transparency on the Financial Markets, and some general consensus has been achieved about the necessity of building a more stringent regulatory framework for the financial system, capable of increasing transparency and stability.
The current regulation, particularly the accounting standards, gives many opportunities for hiding the real situation of a financial institution. There’re many ways of hiding information which can compromise markets opinion about the financial stability of an organization, let me name some well-known examples.
- Massive use of Off-Balance contracts for hiding debt.
http://www.investopedia.com/articles/analyst/022002.asp
- Securitization of high risk loans for hiding counterparty risk.
http://www.investopedia.com/articles/07/subprime-overview.asp
All Financial Crisis have in common that require a bubble to be inflated and burst; but while the bubble is inflated, a hiding mechanism is required to hide the bubble to potential investors.
Obviously, if investors knew that an asset is inflated they wouldn't invest and the bubble could not be inflated. Off-balance accounting postings, assets securitization, Repo 105, OTC Derivatives, have been traditionally accepted and legal accounting practices used as bubbles hiding mechanisms.
In my opinion, the main consequence of this Financial Crisis is moving from a Financial System based in Volume to a Financial System based in efficient management of solvency and liquidity. After this systemic change, growing by inflating and bursting bubbles will not be an option.
Consequently; hiding mechanisms, necessary for inflating bubbles, will not be tolerated.
Every bubble, and the current debt one is a very good example, requires confusing solvency and liquidity. Liquidity increases temporarily the value of an asset, solvency makes the value of the asset long-term sustainable.
http://sapbank.blogspot.co.uk/2013/03/why-do-they-call-it-love-when-they-mean.html
But preventing hiding mechanisms requires more than adjusting the accounting standards, new mechanisms of financial reconciliation are going to be required.
Simplifying, every Financial Asset has a value which depends on a promise of generating future cash-flows and the probability (risk) that those “agreed” cash-flows are successfully delivered.
We work on two main families of valuations; mark to market and mark to model. The first one assumes that the market has perfect information about the value of the asset, the second is build on the hypothesis that the Financial Institution has all the information about the probability of getting successfully the promised cash-flows.
Unfortunately, as the multiple bubbles have made clear, both approaches are incomplete. Injecting or drying liquidity in the Financial System increases and reduces the value of the assets, without any real estimation of its long-term sustainable cash-flows generation capacity; and mark to model estimations have many holes for executives hiding the long-term sustainable value of their assets (Repo 105, Securitization, Off-balance accounting, etc.).
We need a new concept, capable of disclosing the long-term sustainable value of the financial assets.
But this post has become too long, we'll talk about it next week.
Looking forward to read your opinions.
K. Regards,
Ferran.
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