There is a horrid fascination about watching the unprecedented events in the global financial markets. The daily question is what is going to happen next and to whom? Whatever the latest twist and turn – commodity price rise, another fund heading into the arms of the receivers, banks bailing out each other, central banks and regulators struggling to regain control – treasurers not immediately caught up in the events will be ensuring as far as possible that their companies will not be drawn in.
The longer-term question is – when the markets ease themselves out of panic’s grip – what will be the consequences? Talk to the banking industry and it is impossible to avoid a new realism which could at times be mistaken for gloom. Yes, deals are being done, mostly by blue chips with cast-iron reputations, but even so there is no doubt that caution and prudence are the relearned watchwords being uttered by re-empowered credit committees.
The events of the past few years resemble a modern version of the emperor’s new clothes. Now we’ve all been caught out, the regulators are desperate to chart a course away from the current conditions. One common theme is a desire to tackle complexity. In our article on hedging on page 42, the point comes over loud and clear: if you don’t understand what the instrument is doing, and in particular are not completely aware of the downside risk, you should either find out or forget it. Good treasurers don’t give in to pressure to change their mind.
US Treasury Secretary Henry Paulson is trying to prescribe some new medicine to cure us of our current fever of market turmoil for good. More specifically, Paulson says he wants a complete overhaul of the market for mortgage derivatives and has criticised the complexity of the products. For him complexity is the enemy of both transparency and market efficiency.
His comments weren’t greeted with universal approval in the US, but European Commission boss Charlie McCreevy is also tackling complexity and transparency. McCreevy argues that financial innovation in itself is a good thing because it facilitates the more efficient hedging and dispersion of risk, the better management of capital and liquidity, and generally enables financial products to more closely match the needs of market participants. If he is right, the problem isn’t financial innovation, but the understanding of what exactly has been innovated. The opportunities and products that financial innovation spawns have implications for virtually every dimension of risk: regulatory, documentary, credit, market, operational, and last but not least reputational risk.
McCreevy points out that from the board room to the dealing room, the understanding of the nature of the risks associated with innovative financial products and techniques – and the way they are managed and measured – has fallen too far behind the pace of innovation itself. This lack of understanding must be addressed at regulator, supervisor and boardroom level. It seems the only realistic course: we can’t turn back time and uninvent these products. The only option is greater control through greater knowledge.
PETER WILLIAMS
Editor