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CHECKING CORPORATE FUNDAMENTALS

We can revisit the traditional series of steps of the investment processes that extend from the John and Mary Smiths, to the bankers and fund managers, i.e. every reasonable investor. The diagram of investment project parties involved is used as a building block for demonstrating how the stakeholders interact in a basic model. In the orthodox models, the steps of managing business investment decisions are sequential. We can insert reality checks that focus upon risk to keep our risk-return view balanced, put back in question at every phase, leading if necessary to a complete revision of investment projects. Let us see these phases in turn:
1. Formulate a business plan.
2. Match the risk appetite to the risk offer.
3. Due diligence, not least to manage reputation risk.
4. Risk support and methodology.

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INSTINCT VERSUS ABILITY

The finance industry’s basic instinct focuses on hiring the best performing stars, and that may include closing eyes to certain work or character defects. One error is that the “star” bank trader or fund manager is really a shooting-star, one that burns up and disappears from sight. Empirical results show that there is only a tiny core of fund managers who are truly stars. These stars are surrounded by the ephemeral satellites who will slip down the market performance stakes. Hiring these satellites at their peak is to risk underperformance, and even fund losses. Reputational risk is once again means sticking your neck on the block. Banks that realise this stand a better chance of succeeding because their risk perception is correct. Investment banks that held on to a large staff with high salaries and higher bonuses in a down- turn put their balance sheets on the line. Those that shed staff and cut payroll fast put their reputation at danger, being seen as a “bank with a problem”, but their financial strength remains.
Mortgage banks that lend money out at low interest rates and high leverage are in this market risk scenario on a different playing field. The fact that the loan is secured on collateral (the property) may be irrelevant – the real estate value can have dived disastrously. “No problem, we can always redo the property.”
The American early 1980s S&L banking failures underlined the danger of such lax risk perception. We have to adopt realistic risk attitudes about the finance game.
The use of RAROC to test individual lines comes across as a good start to justify the investment. RAROC enables a company to ask if it is really making an acceptable return for the risk from each particular business line. It is a fundamental question that is worth asking whether to:

• remove (reduce capital)
• reinforce (more capital)
• stay in the business line
• or get out of the business.

The financial regulatory authorities hope that Basel II will eventually force banks and financial companies to report real trading losses. RAROC and similar tools are designed to develop richer profit and loss accounts, not cosmetic trading figures to appease the regulators and shareholders.
One of the problems that bedevil banks and funds is the uneven standards of institutional practices. The media have tended to focus so far on fraud and rogue trading, even when this is in the minority of losses. The FSA and London Stock Exchange warns that “previous performance is not a guarantee of future . . . ”
Yet, we are constantly faced with inspecting the value of the track record; poor traders or managers continue where they are protected by the mantra of their previous performance. These professionals have prided themselves upon their skill in recruitment and due diligence, their greater ability to sift out between good and unacceptable customers or staff. Unfortunately, banks’ hiring and due diligence errors have subjected them and their shareholders to significant operational and reputational losses that have financial costs. The Basel Committee reported deficiencies in international banking due diligence know-your-customer (KYC) policies. KYC policies in some countries have significant gaps and in others they are non-existent. Even among countries with well-developed financial markets, the extent of KYC robustness varies.
Thus, the Western economies with a long history of developed banking sectors also have large room or exposure for due diligence errors. This risk needs to be rectified.

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The Move Towards Paper-based (Fiat) Money

What do gunpowder and pasta have in common? According to the Chinese both of these were invented in China long before they appeared in the West. It is generally accepted that the earliest use of paper money was in China more than 1000 years ago towards the end of the Tang dynasty. These were issued by private banks but backed by the state. The use of the paper currency reduced the need to transpor t silver to make payments. This paper was effectively a form of negotiable IOU or promissor y note. The holder of the note could present it to the issuer and receive the stated weight of silver in return.
While Italians may dispute this version of histor y as it relates to pasta they can at least claim to have laid the foundations for the modern banking system in the sixteenth centur y. This was the perfect scam because while the per petrators profited no-one was obviously hurt through their system provided it worked as intended. The per petrators were respected (or at least rich) goldsmiths.
Goldsmiths had to keep quantities of gold on their premises in the form of raw material, work-in-progress and finished products. This gold had to be kept in a secure place and yet be readily accessible. This allowed them to provide a ser vice to rich merchants and landowners to store their gold. They were able to offer one of the earliest safekeeping, or custody, ser vices to their customers. Customers would deliver their gold, usually in the form of coins, to the goldsmith who would issue a receipt for the gold. The receipt represented a claim on this stored gold. The goldsmith would return the gold when this receipt was presented.
A merchant who had to pay a supplier would present his receipt to the goldsmith, take the gold and then make the payment. The supplier would then take the gold back to the goldsmith for safekeeping and receive a receipt in turn. Over time customers realized that it was safer and more convenient to make large payments using these receipts as the medium of exchange. Two issues had to be resolved. The first was that the receipts presented were genuine and represented real claims. The second was that the goldsmith would, and could, honor these claims. The first issue was resolved through the use of wax seals. The second issue depended largely on the reputation of the goldsmiths and perceptions of their integrity and solvency. Over time the gold receipts increasingly displaced gold coins for the settlement of large payments. Coins continued to be used to settle smaller transactions and to make up any difference between the value of the receipts and the required payment. As an aside, these early forms of paper money can be viewed as an asset backed bearer security but by convention it is usually referred to as cash.
These developments led to the adoption of the equivalent of paper money but it did not involve either the creation of money or the establishment of a banking system. These required a leap of imagination. It is difficult to believe this innovation emerged from a committee but the name of the original visionary has been lost in the mists of time. As will become clear goldsmiths had ever y incentive to keep the workings of this system to themselves.
On any given day the amount of actual gold withdrawn by customers was normally only a very small propor tion of the gold that had been deposited with the goldsmith. It became clear that some of this stored gold could be lent out without the knowledge of the depositors. The latter were not concerned whether the coins they received on presentation of their receipt were those initially deposited – only that their value (weight) was the same.
The borrowers rarely withdrew gold itself but instead were issued receipts that acted as a negotiable currency just as those issued to the actual depositors did. The goldsmiths agreed terms and conditions for these loans with the borrowers. The latter paid interest on these loans. The nominal value of receipts circulating in the economy exceeded the value of the gold held by the goldsmiths. In this way money was created.
The system had two potential weaknesses. The first was that the goldsmiths might get greedy and lend out too high propor tion of the gold they held leading to a high level of receipts circulating in the system. This in turn could result in people star ting to question whether the goldsmiths could meet their claims. If enough people with a claim on the goldsmith presented his or her receipts at the same time the goldsmith would be unable to meet all of the claims. The system only worked if depositors were confident that their claims would be met.
The second weakness arose from borrowers who took their loans in the form of gold and subsequently defaulted. This was a real risk when borrowers included kings using such loans to finance wars and merchants buying goods abroad to be shipped home for resale. Members of the first group were at risk from losing their war or being held for ransom, the second of their ship sinking or being attacked by pirates and losing their cargo.
The banking system created by the goldsmiths was unregulated, there were no legal reser ve or capital adequacy requirements, for example. There was no form of depositor protection provided by the likes of the US Federal Deposit Insurance Cor poration (FDIC). It also still relied on the backing of a commodity (gold) with an intrinsic value.
We now have the basis for the modern money system but we need to get rid of the convertibility into gold. We have already discussed some of the practical problems with using gold as a currency such as the tying up of resources to produce and store it that could be better used elsewhere. This is not the major problem, however, which lies in the realm of macroeconomics. By linking the domestic currency to gold a countr y’s money supply is effectively constrained by gold supply. Although there have been periods when gold supply has risen much faster than the real economy, such as happened in Spain, the supply of gold is relatively fixed. In an expanding economy an insufficient level of money supply growth will lead to disinflation, higher unemployment and a lower level of real output. This link can be broken by prohibiting gold withdrawals. This would effectively mean that no-one would know whether the gold was there or not! Policy makers could then determine money supply as deemed necessar y by economic conditions.
These problems are, however, amplified by trade when countries have their own currencies linked to gold. This results in the adoption of what is known as the gold standard and results in a fixed exchange rate system. If holders of sterling were entitled to exchange a £100 note for one ounce of gold and the holders of US dollars could exchange $200 for one ounce this would force a fixed exchange rate of £1 for $2.
Under a gold standard countries with a trade deficit (where the value of their expor ts in terms of gold was less than the value of their impor ts) settle this difference by transferring gold to those countries with a trade sur plus. The outflow of gold leads to a fall in money supply in those countries with a deficit and lower prices making expor ts more competitive as a result. Inflows of gold at creditor nations result in increased money supply, higher prices and less competitive expor ts. As a result of these two pressures the trade balance tends to equilibrium. Higher trade levels result in higher overall output and trade has expanded much more rapidly than economic output since the time of the industrial revolution. The demand for exchange currency has hence grown much faster than the supply of gold. The only way for this demand to be satisfied is for prices to fall, and again leads to higher unemployment and a lower output level than would otherwise be the case.
A gold standard puts policy makers into a straitjacket with no effective means to determine or influence money supply other than through trade tariffs and other barriers that reduce the level of trade. The last attempt to operate using a global fixed exchange rate system failed in 1974 and today few seriously countenance the return to either a fixed exchange rate system or a gold standard.

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PUBLIC STANDARDIZED TRANSACTIONS

A private transaction is not generally reported in the news or to any price-reporting service. Forward contracts are private contracts. Just as in most legal contracts, the parties do not publicly report that they have engaged in a contract. In contrast, a futures transaction is reported to the futures exchange, the clearinghouse, and at least one regulatory agency. The price is recorded and available from price reporting services and even on the Internet.’ We noted that a futures transaction is not customized. In a forward contract, the two parties establish all of the terms of the contract, including the identity of the underlying, the expiration date, and the manner in which the contract is settled (cash or actual delivery) as well as the price. The terms are customized to meet the needs of both parties. In a futures contract, the price is the only term established by the two parties; the exchange establishes all other terms. Moreover, the terms that are established by the exchange are standardized, meaning that the exchange selects a number of choices for underlyings, expiration dates, and a variety of other contract-specific items. These standardized terms are well known to all parties. If a party wishes to trade a futures contract, it must accept these terms. The only alternative would be to create a similar but customized contract on the forward market.
With respect to the underlying, for example, a given asset has a variety of specifications and grades. Consider a futures contract on U.S. Treasury bonds. There are many different Treasury bonds with a variety of characteristics. The futures exchange must decide which Treasury bond or group of bonds the contract covers. One of the most actively traded commodity futures contracts is oil, but there are many different types of oil.’ To which type of oil does the contract apply? The exchange decides at the time it designs the contract. The parties to a forward contract set its expiration at whatever date they want. For a futures contract, the exchange establishes a set of expiration dates. The first specification of the expiration is the month. An exchange might establish that a given futures contract expires only in the months of March, June, September, and December. The second specification determines how far the expirations go out into the future. For example, in January of a given year, there may be expirations of March, June, September, and December. Expirations might also be available for March, June, September, and December of the following year, and perhaps some months of the year after that. The exchange decides which expiration months are appropriate for trading, based on which expirations they believe would be actively traded. Treasury bond futures have expirations going out only about a year, Eurodollar futures, however, have expirations that go out about 10 years.3 The third specification of the expiration is the specific day of expiration. Many, but not all, contracts expire some time during the third week of the expiration month.
The exchange determines a number of other contract characteristics, including the contract size. For example, one Eurodollar futures contract covers $1 million of a Eurodollar time deposit. One U.S. Treasury bond futures contract covers $100,000 face value of Treasury bonds. One futures contract on crude oil covers 1,000 barrels, The exchange also decides on the price quotation unit. For example, Treasury bond futures are quoted in points and 32nds of par of 180. Hence, you will see a price like 104 21/32, which means 104.65625. With a contract size of $100,000, the actual price is $104,656.25.
The exchange also determines what hours of the day trading takes place and at what physical location on the exchange the contract will be traded. Many futures exchanges have a trading floor, which contains octagonal-shaped pits. A contract is assigned to a certain pit. Traders enter the pits and express their willingness ta buy and sell by calling out and/or indicating by hand signals their bids and offers. Some exchanges have electronic trading, which means that trading takes place on computer terminals, generally located in companies’ offices. Some exchanges have both floor trading and electronic trading; some have only one or the other.

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