Systemic Failures and current Financial Crisis. Presentation at the Manchester University 24 th February 2009

1. Systemic Failures and current Financial Crisis.Presentation at the Manchester University24th February 2009 Sanjay Banerji Essex University Business School

2. Current Situation • Global markets are in the middle of a meltdown. • Bear Sterns, Merrill Lynch, Fannie May, Freddie Mac, Lehman Brothers, AIG fell from Grace. • Auto and related Sectors are also reeling. • Globalization of Corporate Scandals from Enron and Madoff to Satyam and many in between including Deloittes- MG/Rover . • Large Scale failures in Checks and Balances of the system.

3. A Downward Spiral • The crisis began with the fall in housing prices and results in a downward spiral. • Infections spread to the whole banking sectors, paralyzing inter-bank loan markets. • Auto, Steel makers and the rest felt the heat. • The economy facing a huge downturn

4. The Questions • How did it come about and what lessons to be learnt? • Future course of Action to avoid systemic failure.

5. Role of Financial Intermediation • To create financial products that help to reduce risk and increase liquidity. • Screening potential borrowers and their projects. • Monitoring ongoing projects.

6. Old Fashion Finance • Lenders deposit money and need withdrawals at short notice. • Banks need longer term commitments to finance long term projects. • Steady flow of new depositors manage the conflicting goals.

7. New Finance – Securitization • Create a pool of assets and create asset-backed securities and sell them to investors. • Banks can unlock their funds lent to borrowers and match the time structure between assets and liabilities.

8. The Problem • Multiple layers of transactions by multiple players replaced single-layer transaction between borrower and lender. • If contracts between the layers are not properly structured and proper safeguards are not in place, this may induce excessive risk taking behaviour at the expense of the other parties. • May lead to a cascading effect.

9. A Simple Picture Payments Borrowers C Banks Loan Money Interest & Principle Savers

10. A Simple Picture Payments Sale Borrowers C Banks I Banks Loan Money Loan Transfer Money Money AIG Savers Subsidiary Money Securitization Debt Asset Investors

11. Information Asymmetry • Some players possess key information which others did not have. • Terms of transactions between different layers did not reflect key information. • Risk was passed to the next layer without responsibilities

12. Propagation of Crisis • Since banks earn a low margin by selling the bundles of loan and bond, it became a low value chain business. • They could make profits by increasing only quantity (volume) of business ignoring quality of borrowers by inducting sub-prime borrowers. • Next layers bundle AAA with below grades securities and selling them as if they are AAA and booked profits. • Default by borrowers created panics and collapse of the giants due to cascading effects on banks’ balance sheet. • Declining house price, increase in interest rate act as triggering elements.

13. Excessive Risk • Excessive amount of risk was being created among different players and multiple layers, which infected all. • Watchdogs including Rating Agencies, Audit firms, Institutional Investors, CEO and independent board of Directors, failed to act on time. • Banks lost trust among themselves and inter-bank loan market collapsed. • All durables (Car, home) need finance for purchase got affected. • Cascading Effect to the rest of the economy. • Role of Debt: Overleveraging and Excessive Risks

14. Deeper Reasons • Poorly designed compensation scheme. • Checks and Balances of all types: • Market (Hedge Funds and Institutional shareholders) • Non Market mechanisms (Rating Agencies, Audit firms) • Institutional safeguards (CEO and independent board of Directors) • Monitoring Agencies ( FSA, SEC) all failed to act on time. • Loss of Trust between intermediaries crippled the credit market even afterwards.

15. Systemic Failure in theTransmission of Information Also presence of checks and balances. Internal checks: Auditors, Supervisors, specialists who could verify authenticity of internal information. Managers, CEO etc. can put in effort determining nature of future information to be revealed. External checks: Regulatory Authorities such as SEC, IRS etc. monitor a firm and check fraudulent activities. Financial Markets. Hedge Fund managers, Private Equity firms, speculators dig information and trade and their orders form the basis of formation of stock price. A huge slip in the stock price implies that someone has a bad news about the company.

16. Structure of compensations • Huge element of severance payments. • 10 largest financial services firms, CEOs were awarded a combined total of $320 million last year, even though the firms reported mortgage-related losses that totaled $55 billion and that wiped out more than $200 billion in shareholder value. • The average American worker might receive about two weeks’ salary for every year they worked at a company. • At Home Depot, Mr. Nardelli’s contract entitled him to 568 weeks of salary ( $210 million exit package) for each of the six years he was chief executive. • Michael Ovitz, Disney’s former chief operating officer, was paid the equivalent of more than 5,000 weeks of salary after just over a year on the job. • Charles Prince of City Corp. felt like Price Charles at the news of ouster! • According to Jensen, 44% of all contracts for CEOs, even those convicted of fraud or embezzlement cannot be fired without a severance payment. In 94 % of the contracts, they cannot be fired for unsatisfactory work without a big severance package . • The figure was less than 25% forty years ago.

17. Building of Trust: Role of Audit • State of balance sheet, measurements of earnings etc. determine cost of capital, ease of financing or refinancing etc. • Substantial Discretion in submitting report: Some are innocuous and lends flexibility, while others are on the verge of neutral and a third element is fraud. • Creative Accounting. • Timing of Income Recognition: Income could be moved backward and forward. • Timing of Sale or treatment of depreciation of fixed capital. Delay in Maintenances or reducing level of inventories

18. Role of Auditors: Continued. • Action that changes income risk: • Underprovison of reserves: especially with respect to default. • Transferring risk through subsidiaries. Poor investments or bad debts to non-consolidated subsidiaries. • Bottom Line: Ex-post Mistakes in Auditing is either due to wrong assumption or manipulation or a combination. • Either way, this creates tendency to ‘’cook the books’’.

19. Consequences of ‘’Creative Accounting” • A Firm’s resources are misallocated. • Garbling of Information. • In bad times, it spills over to other firms and creates difficulties for raising finances. • Loss of Trust

20. Flies in the ointments. • Most of the auditing firms are not publicly traded. • A very few reputed Auditing firms. • Advantage: It attracts best human capital. • Disadvantage: Monopolistic power and lobbying. • It takes a huge scandal ( Enron/ Satyam) for punishment but mechanism for correction is absent otherwise.

21. Auditing: Sum up • Auditing did not cause the crisis directly but once the economy is in bad shape, scandals are out, harder to refinance obligations. • Creative Accounting may lead to defaults and further loss of trust. • Optimal regulation: The real trade-off between too much and too little regulation. • Rewards and Punishments.

22. Conclusion: • Systemic failure. • Strengthening of checks and balances of the institutions who deliver such mechanism. • Multiple Auditors. One to be assigned by regulators and will directly be appointed by regulators. • Active and Independent Board of Directors • Periodic checks and heavy punishments by Regulatory authorities. • Similar to Income tax rules. If a fraud is discovered, firms should be punished heavily.