The Credit Crunch – the accountant’s perspective

We are now in the second year of the ‘credit crunch’. A situation, which manifested itself with relatively minor problems in one sector of the US housing market, has unfolded into a widespread credit and liquidity crisis that threatens a global economic slowdown.

Events have moved rapidly: we know a lot about what has happened but less about how or why. The last few years saw unprecedented growth in the size and profitability of the global banking industry. In 2006 globally banking profits were $788 billion, this was over $150 billion greater that the next most profitable sector: oil, gas and coal. Global banking revenues were 6% of global GDP and its profits per employee were 26 times higher than the average of other industries.

So what are the root causes?

The causes are many, but from a corporate governance perspective the heart of the problem seems to have been:

• A failure in institutions to appreciate and manage the interconnection between the inherent business risks and remuneration incentives
• Remuneration structures/bonuses that encouraged excessive short-termism. This nether supports prudent risk management nor works in the interests of long-term owners
• Risk management departments in banks that lacked influence or power
• Weaknesses in reporting on risk and financial transactions
• A lack of accountability generally within organisations and between them and their owners.

These factors, combined with information asymmetry between parties to transactions and imperfections in regulation and monetary policy, led to an excess of money and supply and, ultimately, to the market dislocation.

Further contributory factors were:

• Over complexity of products and lack of understanding by management of the associated risks
• Excessive reliance on leverage in banks’ business models
• Inter-connectedness of financial institutions
• Misalignment between the interests of originators of, and investors in, complex financial products
• Failure to appreciate cultural and motivational factors, a rigidity of thinking, a lack of desire to change, an attitude of ‘it is not my problem’, inappropriate vision/drivers and, not least, human greed
• Lack of training to enable senior management and board members to understand underlying business models and products, leading to poor oversight by senior executives and a lack of rigorous challenge by independent non-executive directors
• Complacency after a prolonged bull market.

All of these factors played a role; they are complex and interrelated.

Much discussion has centred on possible regulatory reforms. While we accept that changes to regulation may be part of the solution, other changes are needed as part of a more systematic and sustainable solution. The temptation to make scapegoats of individual people or groups should be resisted. While short selling may be, and greed certainly is, part of the problem, there is little to be gained from simply blaming short sellers or ‘greedy bankers’. Banning short selling is simply masking the problem. There is a systemic problem and it is vital that we learn the right lessons.

ACCA believes that the credit crunch can therefore be viewed, in large part, as a failure in corporate governance. This should come as no surprise: previous financial episodes such as the savings and loans bank crisis in the US in the late 1980s, the East Asian crisis in the late 1990s and, of course, the failure of Enron and WorldCom, taught us the importance of sound corporate governance and risk management. We did not learn the lessons in the past and must do so now.

To download the full discussion paper visit www.accaglobal.com/graduates