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'DYNAMICS' EXPLAINED
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So much has been going on in the financial world it is hard to know where to start. The overall impression is too-frequent lack of understanding, and ability to come to grips with, the real issues at the heart of a problem (FT leader 27th May 2010).
The Euro 750 million rescue fund to bail out over-spending eurozone countries is a case in point. Contrast trying to solve a national alcohol problem by setting up readily-accessible liquor stores close to all those affected, who can draw on what they want, when they want. "Oh. By the way, don't bother to pay. Put it on the slate".
The problem with the Eurozone is lack of competitiveness and profitability. Any finance available should be devoted to R&D, business promotion, training, procedure simplification, assistance with new markets. Not making existing financial over-indulgence ever more likely and dangerous.
Similarly with the decision to ban 'shorting' (section 28 below). Well-controlled shorting is an essential part of normal market functioning. The highly effective 'uptick' rule introduced as long ago as 1934, stabilised market behaviour for more than seventy years until withdrawn by the SEC in July 2007. Only since then have major disasters like Lehman been able to occur. Which now, particularly dangerously, spills over into also being able to precipitate soverign risk.
At heart lies the question of what makes business, finance and economics tick? What are the real levers and benchmarks?
Scientists long ago had to address - and solve - this problem.
Well-established scientfic principles enable ordered certainty (eg of a guided missile successfully hitting its target) to be created out of apparently random uncertainty (behaviour of the normal, natural world).
As will be known, business, at heart, consists of achieving meticulous planning and control of total overheads on one hand and meticulous planning and control of total gross margin on the other. Plan and control to ensure the latter comfortably exceeds the former and the business has to succeed, in profit and cash flow terms, come what may (see Techniques Section). In the same way that a well planned and controlled guided missile can be made to hit its target, however turbulent the environment in which it is operating.
Similarly with pension funds (see Pensions Section). Achieve compound growth of around 5%-6% or better and the fund has to succeed, come what may. This notwithstanding inflation. Which indeed actively promotes build-up of fund value in relation to liabilities - the reason for the large pension surpluses and resulting pension contribution holidays that occurred in the 70's / 80's, when UK interest rates peaked at a up to a formidable 15%-17%. (The larger the underlying sum of course the greater the proportionate effect of inflation. Fund Value in any one year is a considerably larger figure being favourably influenced by inflation than far smaller annual pension payouts unfavourably.)
The approach fundamentally alters perception of 'risk'. Thus 'high' or 'low' risk in a pension fund does not associate with 'high' or 'low' yields, but rate of fund buildup. The faster the less risky. And vice versa. Seemingly the opposite of more conventional understanding - as turns out to be the case in other crucial areas of finance.
Similar degrees of speed and precision are possible in business for drawing up forecasts, estimates and cash flows, and keeping management fully briefed on events as they happen ('real time' control).
Predicted outcomes can be relied on to far greater degrees of accuracy. An important consideration perhaps for directors and managers in litigious times.
Such exercises depend on successful detection and measurement of underlying 'dynamics'.
Scientists don't attempt to 'understand' unpredictable behaviour (as Economists attempt in trying to construct for instance an Efficient-Market Hypothesis theory). Scientists accept randomness and uncertainty for what it is and simply correct for it (the guided missile).
The principles are not complex. It is mainly a question of acquiring the necessary knowledge, knowhow, knack and skill to study, track, and understand changing events. And how to accurately sense and attain intended outcomes even in, or perhaps especially in, uncertain and rapidly changing times.
Events leading to the credit crunch can be attributed to lack of 'dynamic' knoweldge and understanding within the financial system. The ability to sense that something is going wrong and being able to draw on techniques of proven ability for dealing with it.
Thus the letter sent to the Queen by eminent economists and others explaining the credit crisis, comments that it was due to "failure of 'imagination' of many bright people". "Failure to see how collectively" events taking place "added up to a series of interconnected imbalances" (ie sumultaneously changing events).
A pension fund has at least five unpredictably changing events taking place simultaneously. Changes in salaries (individual amounts and members joining and leaving the scheme), in investment returns, in inflation, in longevity and in scheme terms.
Yet a given outcome (successful solvency of the fund) can more or less be made to happen, to high degrees of certainty, regardless of external conditions.
1 - 'Ballistics'
A good example of 'dynamic' behaviour is available from the engineering / scientific world. A shell fired from a gun at a certain elevation and certain velocity will travel a known, constant distance.
At a muzzle velocity of 25,000 miles per hour, the shell starts falling over the curve of the Earth, and goes on falling indefinitely, 'orbiting' the Earth at a fixed distance.
2 - 'Escape Velocity'
Beyond 25,000 mph, 'escape velocity' is achieved - centrifugal forces overcoming the pull of gravity - giving rise to space exploration and space travel, to a precision that enables a space probe to be landed on Mars, within feet of its intended touchdown point, after a journey of up to 250 million miles. (An error of just a few parts in 440,000,000,000. Precision levels achievable in the engineering / scientific world.)
3 - Guided-Missile Design
Consider guided-missile design. Anti-aircraft missiles of necessity operate in random, unforecastable, unpredictable environments. What the target is going to do next is unknown and unknowable.
Worse, the target has almost unlimited capacity for deliberately taking whatever evasive action lies in its power to avoid being hit - the ultimate 'control' and 'targeting' challenge. Yet the target does get successfully hit and destroyed.
4 - 'Risk' v 'Uncertainty'
Illustrating that use of Dynamic techniques enables Certainty to be created out of Uncertainty.
It should be noted that 'risk' and 'uncertainty' are then not synonymous. A common misconception.
5 - 'Non-Linearity'
In the ballistics case, increase muzzle velocity by say 5% and the shell lands not 5% further away, but because it also goes higher, it travels further. A 5% change in the cause produces a more than 5% change in the end result.
This is known as 'non-linearity - misleadingly a negative term for a positive outcome - and a powerful feature of dynamics. It allows procedures to be designed for automatically offsetting / counteracting additional, unusual or exceptional RISK or departures from optimum course - on a continuously-operating (ie 'real time') basis.
6 - 'Perpetual Guidance'
The Pensions part of this website illustrates what can be done. The concept of continuous, real-time, guidance is introduced, in the form of ensuring compound growth (including reinvested dividends etc) averages at least 5%-7% pa over the 40 year contribution lifetime of the average member. Forming a real-time, Perpetual Guide and Benchmark for Trustees and Regulators alike.
7 - Bank etc Control
A similar approach is needed for Control of Banks, investment funds, Hedge Funds etc - Brief, immediately available, day by day guidance. For which intuitive understanding and familiarity with 'Dynamics' is necessary.
8 - No Weakness in Short, Brief Regulation
There is no contradiction is this. Briefer need not mean less-effective. Indeed frequently the reverse. A few pages, at most, of well-structured regulation can cover the full range of diverse situations likely to be encountered. Viz the brevity and immediate-applicability of the 5%-7% pensions benchmark.
This feature, most commendably, underlies the G20's recommendations of early September 2009, returning banking practice to previously long-established historic norms. Like restricting bank gearing to no more than 25:1 (4%).
Theoretical calculation indicates that once Gearing gets beyond ~ 25:1 inherent instability sets in, leading to eventual collapse, as indeed happened - a lesson seemingly forgotten, or overlooked, or ignored in lead-up to the credit crisis (actively promoted by Governments, reinforced by legislative loosening, on both sides of the Atlantic).
Similarly with the formerly long-established banking practice of setting aside profits in good times to support bad. The 'buffer' concept (an entrenched feature of science and technology, which systems as mundane as domestic plumbing - water tanks in the roof - depend on for effective operation).
9 - Built-in Safety Margins
Well-designed pension funds aim for compound growth (non-linear) rather than simple growth (linear) in fund value.
It is then relatively straightforward to ensure rate of long term investment gain over the contribution lifetime of each member outpaces rate of growth of pension funding need - however much the funding need may get increased by factors like longevity and inflation in the meantime.
Both of the latter tend to behave merely linearly. Which means they grow in size more slowly than (non-linear) growth in fund value, the latter consequently providing increasing levels of 'cover', 'headroom' 'safety margin' by the time pensions come to be paid.
10 - A Necessary Protection and Safeguard
Without this essential added dimension, Pension Funds would be too borderline, in terms of 'risk', to set up and run. Too borderline to be certain of being able to meet all pension obligations as they fall due, throughout the lifetime of the fund.
The same 'safety-cushion' principle needs to be consciously built into other areas of regulation and control: banking, companies, insurance funds etc. Over-reserving in good times to have extra resources to call on in bad is a typical example (which as mentioned above always used to be a fundamental principle of sound banking practice, now happily restored by G20).
By way of confirmatory evidence of how relatively quickly, easily and precisely it can be done, it will be seen from the table in paragraph 5 of the pensions section of this website that an increase in simple annual growth percentage from 5% to 6%, a 20% increase, increases compound fund value after 40 years from £128,000 to £165,000. A 29% increase.
From 6% to 7%, 17%, produces £215,000. A further 30% improvement.
The favourable disparity grows larger at higher levels (the 'Spare reserve powers' feature). And vice versa unfortunately, which is why low-growth pension funds - ie gilt and bond-based - become increasingly unable to meet their obligations. Another non-linear feature of 'dynamics'.
11 - Long-Term Pension Fund Security
Given that long term pension fund security depends on investment growth in fund value, built up over a member's contribution lifetime of 40 years, investment returns in any one year, however good or bad (high volatility), have little impact on the 40-year average (low volatility).
It is the latter benchmark that forms key guidance. The press is full of reports of alarming pension valuations current methods produce - which for the most part can be safely ignored. Together with avoiding damaging resulting actions otherwise likely to follow, like mistakingly trying to prop up the fund to an extent that positively harms parent company trading. Or reducing benefits. Or offloading the Fund.
Similarly with talk of interest rates affecting 'pension liabilities'. Interest rates (or any other rate) can't affect pension liabilities, which are set in stone by the pension trust deed eg '2/3rds final salary'. Features like interest rates have no bearing of any kind on fund obligations. (Will your own pension get increased or reduced each month by reference to currently prevailing interest rates? Hopefully not! Illustrating the method's fallibility.)
12 - Periodic market downturns in a 40 year period are inevitable, as at present. But there will also be periods of well above average growth. Typical funds over the last few years have achieved low-, medium- and high- double-digit-teens growth, even low-20's, against 5%-7% basic need.
Most Pension Funds are, as a result, considerably more durable, robust, stronger and less vulnerable to inevitable occasional downturn, however seemingly alarming at the time, than current valuation methods suggest
13 - Defined Benefit Schemes under needless threat
A National Association of Pension Funds report in the FT of 23rd January 2009 says defined benefit pension schemes are having to close because the financial strain on sponsoring companies is becoming too great.
But only because, as an added reason, current methods try to achieve (illusory) solvency over an impossibly short, artificial, timescale (until recently just 10 years, but now commendably increased by the pensions regulator in deserving cases to 15-18 years - a significant move in the right direction). Whereas, over the natural 40 year time scale there is little problem. A tragedy is unfolding unnecessarily.
Hence a need for re-working this (and other) regulatory areas.
14 - DB Pension Scheme Simulator
To illustrate the key features of 'internal' pension fund behaviour, a simple spreadsheet model now exists. More accurately described perhaps as a DB Pension Scheme Simulator. Changed factors, like inflation rates, are fed in and changed outcomes studied, producing frequently unexpected, counter-intuitive, results.
Inflation for instance considerably assists Fund-build up, far outweighing anything increased pensions impose (annual pensions are but a tiny fraction of fund size).
15 - Effectiveness of Regulatory Procedures
The effectiveness of regulatory procedures (and associated operational-management procedures) in general depends critically on whether they work towards creating long term, stable, secure, low volatility structures - banks, pension funds, plc's, insurance companies, hedge funds etc.
Or whether they intentionally (eg shorting) or unintentionally create volatility and instability.
An example of the latter is Fair Value. Fair Value is a valuable technique, provided it is not based on present values. The only values that can legitimately be used must accurately anchor to timing of the underlying event - date of redemption of the loan or sale of the asset. Otherwise disruptive short-term instability is created, not durable long-term stability.
16 - Regulatory Shortcomings
Lord Turner, Chairman of the Financial Services Authority, commenting after HBOS's shock £10 billion loss, said "With hindsight, the FSA, like other authorities throughout the world, focused too much on individual institutions and processes...and not adequately on the totality of the systemic risks across the whole system." "It was an intellectual failure" (his description). "Regulators round the world had failed to recognise that by 2004 the banking system was developing in a way that created large systemic risk".
17 - 'Dynamic' Understanding Needed
At root, this is an indication of failure to recognise, or focus on, the 'dynamics' of the situation. Concentrating instead on the 'statics' (see later).
He goes on, somewhat ominously, "there are very, very deep issues about how we get it right in future". Indeed, but it is not as difficult as he seems to think.
18 - Structural Remedy
He should not get too daunted. As he and others discover, familiarisation with 'dynamics' (which, as hinted by his remarks, seems largely absent in the banking and regulatory system, indeed the financial world in general) - if it can be brought about - offers a ready-made solution (see under The Solution, second last heading below).
Kenneth Clark was reported as saying " The FSA adopted a 'box-ticking' approach" instead of what is required. See also under Chicago Board Options Exchange, Section 53 and particularly under Alleged Satyam Fraud, Section 50.
19 - Effective Regulatory Procedures Produce Stability
'Good' Regulation must accurately reflect real-life behaviour. Angela Merkel, who as will be known trained as a physicist in East Germany, went on record in mid-January as saying that natural behaviour in the physical world, left undisturbed by outside influences (an essential caveat), tends towards equilibrium. In other words stability.
20 - Market forces
Similarly in the financial world (which is comforting), which has a bearing on whether market forces can be relied on produce equilibrium, ie stabilise, the system? The essence of economists' Efficient Market Hypothesis (EMH).
Yes, provided no non-natural, artificial, external, extraneous factors (like shorting) are involved. If they are, they have to be specifically identified and taken into account, before any workable theory can emerge.
21 - Ineffective Regulatory Procedures Produce Instability and Volatility
By definition regulation that does not reflect real-life behaviour needs to be reworked. Unfortunately unproven Economic dogma has somehow been allowed to intrude the scene, producing misleading outcomes. Pension 'deficit' measurement being perhaps a prime example, including measurement volatility being introduced where little exists in the real world.
22 - 'Dynamic' Understanding a strong indicator of Management Success in Business
People seem either to have an intuitive gut-feel for dynamics (changing, moving, real life behaviour) or not. There rarely seems to be a half-way stage.
Those who have a strong gut-feel for dynamics tend to be significantly more successful in business (and banking, investment etc), make fewer wrong moves and produce consistently better judgements, than those who do not.
This is not surprising, in the light of the fact that the 'dynamic'approach accurately mirrors natural, real-life behaviour.
23 - Successful Companies
In terms of resulting success Berkshire Hathaway is perhaps a pre-eminent example, which went into the economic downturn with its acquisition powder bone dry, holding unencumbered cash or near-cash equivalents of $106.1 billion.
24 - Successful Bankers
One of the UK's most respected bankers, reputed for sound judgement, and now deservedly in the House of Lords, was well grounded in Dynamics during his early years of training.
25 - Reduction in VAT rates. 'Proportionality'
Having an intuitive gut-feel for, and understanding of, Proportionality is another key feature of 'Dynamics'.
As an example of where such understanding may have been lacking, until 1st January 2010, UK VAT rates were reduced from 17.5% to 15%, a saving of 2.5% as far as the shopper is concerned, to whom such small savings were however likely to have negligible impact on buying decisions, especially when discounts of up to 70% were on offer from stores. The proportionality is derisory.
As far as the Government is concerned however 2.5% was a significant proportion of the Government's former 17.5% VAT receipts, amounting to 14% reduction in overall VAT revenue.
The Government needs to maintain every scrap of income it can possibly muster in present circumstances (to the extent it fails, the taxpayer will have to pick up the bill, eventually). This adversely affected the government (and thus all of us) a great deal more than it benefited any casual shopper; or market demand considerations.
26 - 12% Coupon on Government Preference Shares
Another 'proportionality' illustration. Banks in which Government has taken a stake face a massive 12% coupon on their Preference Shares, which is likely to drain profits out of the operation to such an extent there will be insufficient left for rebuilding bank balance sheets - the whole purpose of trying to get the banking sector lending normally once again.
If building up bank balance sheets from retained earnings is the priority, which it must be, preference coupon rates certainly no higher than say 3%-4% might be the limit.
27 - Conversely, as an Example of the Benefits Sound Understanding of 'Dynamics' can Bring: are Derisory Interest Rates a Cunning Plan to Induce Switch to Equities?
At the beginning of 2009, sound 'gut-feel' was in the process of bringing crucially beneficial effects to several key areas of the economy simultaneously.
Interest rates on deposits became so vanishingly small, the comparative risk of switching to equities grew less, and the incentives and rewards from doing so grew more, by the day, despite continued market turbulence.
It may have been a bold move with the intentional side effects of helping to kick-start and accelerate development of equity markets once more. Markets and market participants would have benefited, along with investors, pension funds, investment funds, companies, banks, and the economy as a whole.
28 - Dangers of Removing Ban on Short-Selling
Most unfortunately - despite strong representations to the contrary - the initiative was killed, stone dead, by the FSA's decision the remove the ban on short-selling of selected bank and financial stocks on 16th January 2009, which was very-necessarily introduced last September to prevent market wipe-out.
29 - Abrupt Market Reversal
The week the temporary shorting ban was not renewed, the FTSE retreated a torrid 6.7%, abruptly breaking the trend of uninterrupted weekly rises since the start of the year. Since then the market has been dead and gone nowhere. All the old fears have returned. A priceless opportunity has been gratuitously thrown away.
30 - 'Shorting' RBS Reaps £270 million (FT Headline 27th January 2009)
The FT reported Paulson & Co "one of the world's biggest hedge funds", made a profit of at least £270 million betting on a fall in share price of the Royal Bank of Scotland over the past four months.
Market operators were pleased enough (mainly a small handful of hedge funds). But what of the thousands, tens of thousands, of ordinary investors, investment funds, pension funds and others who lost £270 million in the process?
They were gutted and all trust in the normal functioning of the markets once again evaporated. Would-be investors are once again firmly staying on the sidelines, not wishing to lose even more.
The FSA's undertaking that the "temporary ban can be reinstated at any time", whilst welcome, meant the shorting ban continued to hang over the market like a sword of Damocles, creating continuing fear and uncertainty for investors and unduly depressing sentiment.
31 - Return to Market Stability Crucially Depends on Reinstatement of the 1934 Uptick Rule
The Uptick rule, which requires "every short sale transaction to be entered at a price that is higher than the price of the previous trade", (ie no shorting downwards, only upwards) was introduced in America in the aftermath of the Great Depression and successfully prevented shorting for 74 years.
The rationale is just as compelling today as when first introduced 76 years ago "The Uptick Rule prevents short sellers adding to the downward momentum when the price is already experiencing sharp declines". Precisely.
Shorting of market instruments not caught by this definition, eg Futures are exempt from the rule. Why? "Such instruments can be shorted on the downtick because they are highly liquid and have enough buyers willing to enter into a long position, ensuring the price will rarely be driven downwards".
32 - Regulatory Alert
CAVEAT. This may be true in normal times, but may not in abnormal times, like the present. If liquidity for instance suddenly evaporates, market instruments affected need to be brought under regulatory control, a change that Regulators need to keep on regular alert for.
33 - Market Manipulation post 6th July 2007
Market manipulation became so extensive from 6th July 2007 onwards the stockmarket lost its reputation for honest and fair dealing (prices broadly related to underlying company merit).
Investors no longer know where they stood and lost considerable sums in the process. Finally largely withdrawing from the scene.
A return to market stability, and the beginning of recovery in the Economy, crucially depends on reinstatement of the Uptick Rule.
34 - All the Major Bank Collapses have Occurred since the Uptick Rule was no longer Available to act as Market Stabiliser
Nearly everything that has gone wrong, the collapse of Lehman Bros (15th September 2008), the run on Morgan Stanley, Goldman Sachs etc, etc, occurred in the relatively few months after the uptick rule was suspended. Other factors were also of course involved, but there is a profound message here.
Lehman, Morgan Stanley, Goldman Sachs etc might not have happened - and certainly not as severely, quickly and irredeemably as they did - had the uptick rule still been in place.
Lehman Brothers share price collapsed from $82 to just $4, towards the end so precipitately that the authorities had only a weekend to decide what to do, and may well have made a catastrophic (if more than understandable) mistake as a result.
Had the market been left free to act under the influence of normal investor sentiment alone, the speed of downturn would almost certainly have been slower, giving days, if not some weeks, to decide what to do. Almost certainly resulting in a far less permanently-damaging outcome.
Economic Recovery crucially depends on Recovery of the Stock Market. If Stock Market Recovery is being frustrated by continuance of Shorting, so is Economic Recovery. It is as if a few hedge funds are being preserved, regardless of risk to the banking system as a whole.
Shorting is a Dagger aimed at the heart of the Economic System, poised to strike at a moment's notice.
The ever-present nature of the threat is well-illustrated by the FT 's headline the day after the above was written: "Fears for BofA and Citi spook markets". "Citi fell 22.3% in the day, bringing its losses this week to nearly 44%." "Bank of America fell another 3.6%, a loss for the week of 33.6%." Shorting is a self-primed fuse waiting to go off at any moment. A hugely destructive element, buried in the very heart of the economic system.
35 - Uncontrolled 'Shorting' remains one of the most dangerous threats to stability of the financial scene
Shorting procedures detect adverse trends at the earliest possible moment (unfortunately) and immediately and deliberately introduce procedures for making them worse (as far as the company, stock market, investors, pension fund investors, the financial sector and economy as a whole are concerned, but not of course for the individual market operators deliberately precipitating the action, who gain hugely - at others' expense).
It is the reverse of the pension fund example, where departures from course are detected at the earliest possible moment and immediately corrected, 'negated' (applying so called 'Negative-Feedback', negating differences between actual and intended course; 'counter-cyclical' in economic terms, smoothing peaks and troughs). Enabling stability to be restored immediately the first signs of instability arise.
The reverse: 'Positive Feedback' ('pro-cyclical' in economic terms) accentuates departure from course, and at an accelerating rate. The aim is to create deliberate instability by precipitating and accentuating artificial downward spirals.
"The deeper and quicker the better" will be the mantra of the market operators, who must positively embrace developments like 'fair value' in doing so much of their work for them. Initiating ever more rapid instability, earlier than might otherwise be the case - softening up the scene earlier and deeper in advance.
If the dynamics of the wider scene were fully and adequately appreciated, so great would be the degree of alarm, that an immediate, permanent, ban on all forms of short-selling would be introduced. (Concerted inter-government action may also be needed to deal with any legal and other issues arising.)
36 - Why no Regulatory Warnings?
The question arises is why the financial scene was not warned, at the time, about the dangers of market-destructive financial spirals being initiated, and materially assisted in their speed and depth of progress, by the introduction of techniques like Fair Value, Shorting etc?
Presumably no one had any idea that such an outcome would happen. Again pointing to lack of appreciation of the dynamics in the wider scene. (Understanding of Dynamic behaviour is not covered in any pre-qualification or post-qualification training).
37 - G20 Meeting
All forms of shorting are contrary to the 'corrective' needs of the scene. Most happily, the G20 meeting agreed to reinstatement of the uptick rule in suitable form. The SEC has already circulated suggestions for comment, which could transform confidence in stockmarkets in spearheading world economic recovery.
The G20 also agreed to look at the effectiveness of IFRS accounting, an equally important development (eg Section 11).
38 - 'Good' Regulation / Management Guidance
The above 'Cunning Plan' (until put in jeopardy by removal of the ban) was a particularly powerful example of 'good' regulation / operational management guidance (ideally forming twin sides of the same coin) in favourably influencing actual behaviour on the ground - the purpose of all good Regulation.
Although 'influencing' rather then 'compelling' a given outcome, it still forms a powerful carrot and stick approach. The downside (doing nothing) offers certainty of disadvantage. The upside, at least reasonable prospects of benefit. Self-interest powerfully brought to bear for the common good. Again, the ideal form of Regulation.
39 - 'Good' v 'Bad' Control and Regulation
Ill-designed control and regulatory systems for instance try and block undesirable trends, frequently stifling new initiatives and new ways of operating in the process. All the dangers of 'over-regulation' result (maximum management distraction for minimum end result).
Well-designed control systems (eg guided-missile design) work on an altogether different principle, channelling whatever trends arise into most favourable outcomes. A fundamentally different approach - in dynamic terms preserving 'forward thrust' and 'momentum'.
'Blocking' forms of control ('static') are almost inevitably unduly bureaucratic, slow and time-consuming. For a start, trying to establish the catch-all environment needed makes it near-impossible to keep pace with, and therefore favourably influence, events as they happen (one of the key requirements).
'Channelling' forms ('dynamic') allow fast, light-touch, real-time control.
40 - Not 'More Regulation' / Management Guidance but Better- Content, More Directly-Applicable Regulation / Guidance
Alan Greenspan towards the end of 2008 went on record, amidst all the clamour for 'more regulation', warning against the dangers of stifling new initiatives and over-ponderous regulation:
Far less regulation is needed in terms of volume, slowness, and confusion of content.
Far more in improved content, speed and direct applicability, in successfully bringing about real time action on the ground.
41 - Immense Real-life Power of Dynamics
'Dynamics' is an immensely powerful force for achieving 'good' real-life outcomes - eg pensions, where the seemingly impossible is made possible: healthy, stable pension funds, capable of meeting all pension obligations as they fall due, despite ravages of factors like inflation and longevity, at a cost to the employer that does not damage, limit or hinder business operations.
But unfortunately Dynamics is also an immensely powerful force for creating thoroughly 'bad' real-life outcomes (like perhaps the proverbial example of the butterfly and hurricane, see under The One Exception heading below) - of which 'shorting' is perhaps one of the most threatening current examples.
42 - Summary of Credit Crisis
The FT produced a valuable summary of the credit crisis "how gamblers broke the banks" on 16th December 2008. Nowhere (with one exception, dealt with below) does there seem to be any mention or awareness of 'dynamics'.
Despite the fact the financial world is almost exclusively 'dynamic' in nature.
43 - Knowledge Inadequacy
Without a strong, intuitive, gut-feel for 'dynamics' it is not possible to have full understanding of what is happening in the financial scene.
Still less, to be able to devise effective 'control' systems for ensuring desirable outcomes are achieved. (Which may explain the situation set out in the PS below.)
44 - The One-Exception
The one exception - someone with 'dynamic' gut-feel, mentioned earlier, lies in John Kay's remarks in the FT article. But only in a limited way. "We now" [?] "understand that economies are complex, dynamic, non-linear systems in which small differences to initial conditions can make large differences to final outcomes - the proverbial flapping of a butterfly's wings that causes a hurricane".
But undesirable outcomes like this only happen if active steps are not taken to deal with such dangers and turn the situation to good account, as described earlier. (The possibility of being able to do so does not seem to occur to those concerned, which is where the root cause of inaction may originate.)
45 - Why never Considered?
Positively grasped and put to good use, far-reaching benefits result from understanding and using 'dynamics' as the discussion above hopefully indicates.
46 - G20 Meeting 16th November 2008
The conclusion of the G20 Group of Nations meeting on 26th November was that: "the International Accounting Standard Setter should promote financial stability". (And by implication so should bank, company etc management teams.)
Only to be met with the rather puzzling reaction: "accounting is about transparency and that's a different subject from financial stability".
All good control and regulatory systems exhibit transparency - immediate understandability - one of a group of key features, like comparability, that can be taken for granted.
47 - Creating Financial Stability
In order to be able to design and operate financially stable banks, financially stable pension funds, financially stable companies, financially stable insurance companies, financially stable hedge funds, an in-depth knowledge of dynamics is essential. It can't be done without such knowledge.
The adverse reaction just mentioned may therefore be further tangible evidence that the necessary knowledge and experience may be largely, or almost wholly, absent from the financial scene (also tending to confirm the PS at foot of the page below), which clearly needs (urgent) remedying.
48 - Another Example - Badoff
On 22nd December 2008 the Bernard Badoff $50 billion alleged fraud story broke, allegedly going back up to 20 years or more, and allegedly involving undetected fraudulent accounts.
49 - Fraud and Error can be quickly detected using 'Pattern Detection' Analysis
'Pattern-Detection' analysis applied to accounts (another valuable, quick-to-use, 'dynamic' technique) quickly reveals whether the financial information is soundly based or contains error, or worse, fraud. Had those around at the time been 'Dynamically' aware, the alleged fraud would almost certainly have been detected almost from the moment it first began to occur (whenever that was). The same was true of Enron of course.
50 - Alleged Satyam Fraud
Yet another example of alleged blatant fraud surfaced on 12th January 2009, the Financial Times reporting "Mr Raju claims he inflated profits and cash whilst understating liabilities".
"Mr Raju allegedly has made at least $1.4 billion vanish from the once venerable software giant. If believed, in the second quarter of 2008 Satyam made an operating profit of Rs610m, only $3.75 per employee per day. This number stretches credulity by a wide margin.."
"The alleged fraud occurred in a highly regulated company listed in two jurisdictions with supposedly high degrees of regulation. And has a Big Four accountancy firm as auditor. All quarterly and annual filings, including disclosures under Indian and US Generally Accepted Accounting Principles were regularly filed with regulators in the US and India along with regular filings with Indian exchanges and NYSE Euronext. Yet there is a hole of more than $1 billion in cash alone - cash, which is almost impossible to fake in the books."
Satyam's auditors reacted by saying "all the right boxes were ticked" which must cast serious doubt on the methodologies being used (see also Mr Brodsky's views below).
Again 'Pattern-Detection' analysis applied to the accounts, would, at any time, have quickly revealed whether the financial information was soundly based.
51 - Regulatory Procedures Seem to Lack 'Bite'
One can't escape the conclusion that current regulatory procedures in the main seem to be largely 'all form and no content'. They lack 'teeth'. They lack 'bite'. Radical re-thinking seems necessary.
52 - No Surprise to Scientists, Mathematicians or Engineers
None of this is new to scientists, engineers or mathematicians. Who for generations have gone on to design systems that exploit the (considerable) opportunities opened up. But almost entirely new, seemingly, to almost everyone in the financial world.
53 - Chicago Board Options Exchange
The situation may be even more daunting than commonly supposed, judging by the comment in the FT on 24th December 2008:
"Bill Brodsky, chief executive of the Chicago Board Options Exchange" (a 'dynamic' enough operation to suit anyone's tastes - someone like him would make an ideal SEC or FSA Chief Executive) "said the Madoff scandal showed the inspectors had not received enough training to enable them sufficiently to check for fraud. The people doing the examinations have no clue what the right questions are to ask. Going in and asking questions out of a manual does not help you understand how a business works". So-called 'Box-ticking'.
54 - Why the almost Universal Absence of 'Dynamic' Knowledge?
Why do the techniques seem so universally new and unfamiliar to the financial scene, as the FT Supplement hints?
Perhaps for at least some of the reasons given above.
And why the seeming reluctance to adopt reliable techniques to handle the financial world's undoubted problems?
The first needs to be in place before the second can happen.
55 - The Solution
All concerned, especially regulators and operational management teams first and foremost, need to be made quickly familiar with the principles of dynamics and the way they can be put to good use in tangibly bringing about favourable outcomes.
It need take no longer than a single day's course.
The sooner this can happen, the neater, more compact, less arduous, faster-acting, better-directed and considerably more effective, control and regulation of the financial scene will become.
Brian Warnes MA (Oxford, Natural Sciences) FCA FRSA.
PS. A major regret in the UK is that the small group of people who did have at least an intuitive gut-feel for dynamics, through long experience of day-to-day, hands-on, supervision of the banking system at senior levels from within the Bank of England; coupled with ability directly to control the money supply through direct buying and selling of government stock; were precipitately removed from responsibility, on the Bank being given its independence in 1997.
No other group seemingly existed, inside or outside the financial system, with the necessary knowledge and experience to take on the task.
56 - Ongoing Problem
From which the scene is still suffering - acutely - despite all the best endeavours to try and remedy the many problems that have arisen, and continue to arise, as a result.
Not just in the UK but seemingly also in America, viz: the Madoff SEC confusion.
BW
'Dynamics' Explained
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