Reliable data and financial reform (part II)

Author: | Published: 1 Dec 2005
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King and Wood

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Failure to achieve a state of reliable data means that:

  • Chinese banks will be at a disadvantage to other banks in raising capital, subordinated debt and borrowed senior funds, because of the uncertainty premium the market will place on measuring the denominator in their current regulatory capital ratios. This in turn will constrain Chinese banks' ability to participate more in the Chinese economy. In particular, they will not be able to compete with foreign banking organizations in taking advantage of incentives in the Basle regime for trading, OTC derivatives and modelling.
  • The secondary securities market development will be limited by the lack of access to corporate information (and, in the case of financial institution issuers, financial asset information), which in turn will limit the development of the primary securities market.
  • The listed warrant market will suffer from wide bid-ask spreads, as warrant pricing and stock price volatility remain disconnected.
  • Insurers will be prone to serious liquidity gaps between their assets and liabilities, as actuarial experience and asset liquidity remain disconnected.
  • Commodities exchange development will be chilled as: (a) the potential for unfunded liability of the clearinghouse will be difficult to quantify with precision; and (b) market-making remains tentative due to disconnect between asset prices and futures prices.

To achieve a state of reliable data, experience has shown it is necessary, before anything else (including purchasing expensive information technology), to define what data is being sought. This definition must be clear, so that the consequences for failure or success in generating and capturing this data are equally clear. This definition can only be constructed from the ground up, constantly aggregating these inputs until the texture of the whole statistical pool is evident.

Knowing each customer in terms of its loss history, mapping the price of each financial asset over time against different combinations of market movements, and studying the history of earnings presided over by a given set of managers over a given set of assets are the elements. Further refinement is to obtain greater and greater granularity, and ultimately having managers capable of exercising judgment to override data-driven models when appropriate. The rate at which these elemental tasks are performed at the individual decision-maker level at financial institutions and aggregated and supervised (by management and by regulators) and perhaps validated by Reuters, ratings agencies, and other vendors independent of such financial institutions, can be said to measure the level of modernization of a financial system. Conversely, the lack of will to perform these tasks eventually catches up with originators, and feeds into a greater fool theory of financial asset ownership in the secondary market.

The state of reliable data cannot be achieved overnight – much trial and error is inevitable, and must by necessity trail (but always keep within sight) the lead of product development. It is hoped that foreigners strategically investing in the domestic banks, insurers and securities firms, and the joint ventures they set up to create new banks, securities firms, fund managers and asset management companies, will catalyse the process. Risk management is not glamorous, and is considered by some to be a cost centre. Yet so are loss reserves and uncertainty discounts. It is worth considering the value of commitment to risk management. If it is valued appropriately, then minority investors with the requisite skill sets will put them on the table.

As foreign direct investment becomes more complex and financially oriented, perhaps the core issue between the parties is the valuation of the tangible assets, the cash flows, and the intangibles (or goodwill) that the parties initially contribute, and the negotiation of binding and enforceable covenants that aim to enhance this value over time. Careful selection of one's partners up front, and patience at the back-end for results to emerge, are the attributes of parties that are committed to financial reform. This is due to the fact that objective, testable results of risk management contributions, as well as other contributions of goodwill from the parties, have a significant gestation period (similar to the requirement that data must season). If, despite the care up front and the subsequent patience shown, these results fall short of the requirements of the covenants, then termination of parts or all of the cooperation agreement, together with other adjustments (monetary and/or governance-related) to the relationship, should be the consequence.

Conversely, unilateral termination rights should be scrutinized closely because they tend to chill willingness to make the contributions that are the raison d'etre of successful partnerships.

Fred Chang