Compliance, complexity, and crisis…

Although we are approaching the 10th anniversary of the start of the Great Financial Crisis, its effects linger in many areas of the financial arena, let alone monetary, fiscal and economic policy.

Banks are still being fined by, or reaching settlements with shareholders, customers, regulators and governments; with the amounts involved in the billions of US dollars, or equivalent- all of which depletes capital, damages franchises and affects valuations.

So, the question has to be posed: have we really learnt anything that can minimize the risks of a repeat?

To try to counteract the perceived risk of malfeasance and to placate regulators and customers, banks and other financial institutions, including (re)insurers now spend a remarkably large proportion of their costs on “compliance” and “know your customer” in all their many guises. The processes established are considered essential to survival, even if there are now signs that some of the regulatory burden may be lifted. The paradox is that, in doing so, and because much of the work can become “formulaic”, they may well be diverting resources from areas that may become the source of the dangers to come.

Yet, even if that occurs, can it really be said that behaviours have changed? Of course, banks have been convenient and “soft” targets, because they depend upon on governments and regulators for their very existences. Lose that banking licence and you are out of business. And there are many equivalent scandals in the non-financial corporate world that provide ample evidence that banks are not such outliers after all.

Nevertheless, the concern lingers that it is only a matter of time before another crisis erupts- and it will almost certainly be from an unexpected quarter, because the obvious causes are exactly that.

Banks and (re)insurance companies are notoriously opaque when it comes to what is actually going on within their business models; and their complexity often creates a dissonance between the reality of their risks and economics and the constraints of the regulatory and accounting standards to which they are subject, which tend to be “one size fits all”, or barnacled with accretions that make a mockery of the supposed desire for transparency and comprehension.

As a result, regulators, have repeatedly tried to improve transparency by requiring periodic publication of so-called “Pillar 3” disclosures, which are intended to provide the reader with sufficient detail and granularity of data that trends become more easily discernible and “the market” enforces discipline by increasing an institution’s cost of deposits or capital, or the spreads on its debt.

Such efforts are laudable. However, the nature of the data are such that a fairly sophisticated understanding of banking or (re)insurance is required, which then leads to the further question of whether there are sufficient independent and objective “observers” who will be both willing and able to be “enforcers”.

And, as we said above, the next crisis, when it occurs, will almost certainly have as its origin factors that no-one will have foreseen; or, if they have, they will be derided as “paranoid”, or misguided. This means that one should remain vigilant at all times about indicators that a tipping point or Minsky Moment has been reached, and that the next cascade of economic and financial damage has begun.

In our opinion, looking too much in the “read view mirror”, while at the same time focusing on information that is both complex and unlikely to highlight new risks, too much time and effort is devoted to appearances and too little to actual risk management.

At Awbury, while reviewing required disclosures for potential signals and trends, we believe that we have to remain vigilant about the overall economic environment, as well as attuned the appearance of new signals of stress.

The nature of our business model is such that we believe firmly in radical transparency, and providing clarity not obfuscation with our clients and partners; because ultimately all effective businesses are built on both trust and a proper alignment of interests. Pretending one has a “magical black box” rarely ends well.

The Awbury Team

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