Search the Internet          Tips  Sites: Finance, Investment

Financial economy: master or servant?

A V Rajwade

After reading reports about Andrew Fastow, the disgraced chief financial officer of Enron (who was at the heart of the partnership structures created to hide debts), and Mark Swartz, CFO of Tyco, another troubled company which had grown by a series of acquisitions, I have been thinking of the changing role of the finance function in industry and, indeed, the economy.

(Incidentally, both Mr Fastow and Mr Swartz were winners of Excellence Awards from CFO Magazine.)

In a way, the change in designations in modern corporate hierarchies is evidence of how the role has changed over the past half a century - from the humble chief accountant to the more powerful financial controller to the glamorous chief financial officer.

Initially, the function consisted principally of bookkeeping and accounting as per the regulatory requirements, a pure service activity.

Apart from knowledge of accounting and, hopefully, a professional qualification, a chief accountant's other attribute was his trustworthiness. At a later date, the function got elevated to financial control.

Accounting remained a part, but several other things got added to it: project or investment evaluation, budgeting and performance comparisons, analysis of peer group numbers, cash management, money raising, etc.

Though the role expanded, it remained a service function, not a profit centre.

In the 1970s and, more so, the 1980s, the financial environment itself changed dramatically. Exchange rates were floated and interest rates became far more volatile.

Again, different ways of raising money became available and choices had to be made. Thus from accounting, analysis and control, the role had to evolve into a managerial one of making choices and decisions - or at least recommending them.

If the role of the corporate finance function expanded, the volatility in exchange and interest rates led to a far more glamorous and lucrative function in financial services: that of a trader in bonds or currencies.

These so-called masters of the universe, often in their 20s and 30s, made hundreds of millions of "trading profits" for their employers - principally commercial and investment banks, and hedge funds - and tens of millions in bonuses for themselves.

Trading in this sense is, of course, a euphemism for speculation, a business the traditional finance man or banker despised. The spread of modern financial theory in areas like portfolio management, option pricing and hedging, and the introduction of rocket scientists to develop newer and ever more complex derivative "products" opened up more opportunities.

(Somehow - perhaps my age shows - I am not comfortable with the word "product" for such instruments or mechanisms. It reminds me too much of toothpaste and toilet soaps!).

As "plain vanilla" mechanisms lost their allure - too much competition and razor-thin margins - complex, proprietary structures became the marketing teams' favourites.

Originally meant to hedge risks, derivatives came to be used for taking on risks. Many clients did not understand what they were buying - and a spate of court cases resulted.

Yet, derivatives remain a glamorous part of the financial world. To be sure, the "masters of the universe" were occasionally brought down to earth by events like the collapse of Barings and the failure of LTCM, but remained an extremely well-remunerated lot.

Another breed of investment bankers, helped by complex mathematics, developed a huge market in structured financial products. Asset-backed securities issued by special purpose entities, collateralised mortgage obligations and the like became buzzwords in the financial markets.

Financial engineering became part of, indeed sometimes replaced, corporate strategy.

The prosperity of bankers and money traders (in currencies and bonds) hardly escaped the corporate world. It realised that society pays far more to those who trade in assets than to those who create or manage them.

Mergers and acquisitions became a crucial element of business growth. The share price became increasingly important because, in the business of buying companies, it provided the cheapest currency.

If the glamorous chief executive officers of companies, ranging from WorldCom to Tyco to Vivendi in Europe, spent much of their time, energy and talent in buying and selling companies, advised and, indeed, egged on by investment bankers, the head of the finance function, now glorified as the chief financial officer, often was put in charge of maintaining the price of the currency the CEO would use - namely the share price.

If this meant that quarterly results had to be "managed", so be it. If this meant that investment banks had to be paid huge fees for advisory work incidentally (and also to get "buy" recommendation on the share), the CFO did not hesitate. If this meant that corners had to be cut, that highly creative accounting had to be employed, he was up to it.

He also found that - whatever the efficient market theory may say - it was possible to maintain prices way above those justified by fundamentals for quite some time, enough anyway to serve his purpose, with the help of investment bankers' recommendations, with "pro forma" accounts, with numerous other dodges to hide the true state of affairs.

Almost any price could be, and was, justified by discounting the earnings ten years hence at a suitable rate.

On this subject, one is reminded of a brilliant insight into modern financial markets provided by Professor Charles Goodhart. Goodhart's law, initially propounded for monetary policy, states that the link between money supply and inflation would break down if the former became a target of policy.

More generally, when a measure becomes the target, it ceases to be a good measure of anything. For example, earning per share is a measure of how well the company is doing (and the price earning ratio that of the under- or over-pricing of a share). When it becomes a target however, it ceases to be a reliable indicator.

All efforts then go to achieve the target and the number becomes substantially meaningless as evidence of anything. In the more aggressive corporation in the US, it became the CFO's job to meet this target.

And that is perhaps where his downfall started as Mr Fastow certainly evidences in spades.

The larger question, of course, is whether the pendulum has not swung too much in favour of the financial economy - exchange, equity, money markets and their players - and away from the "real" economy; whether the wide gap in compensation levels is healthy; whether the fortunes of even large companies and indeed economies should be subject to the whims of a few bond and currency traders and equity fund managers; whether the prospects of as creative a company as, say, Sony should be determined by exchange market speculation; whether sacking thousands of employees and closing plants to meet "Wall Street expectations" is the right thing to do, morally or economically.

As somebody who has spent all his working life in the financial economy, one increasingly feels the need for a greater balance of power between the real and the financial economy.

A V Rajwade is a forex and risk management consultant

Powered by

ALSO READ:
The Rediff Budget Special
The Rediff-Business Standard Special
Money