Investments and risk mitigation- back to basics
A book published more than a decade ago entitled Corporate Scandals: The Many Faces of Greed[1] stated that: “Despite the contributions of critical thinkers through the ages, most cultures and their associated institutions have had only limited success in achieving truly virtuous societies in which the behaviour of individuals conformed with the culture’s highest ideals.”
The corporate scandals in the 20th century in different parts of the world have continued into this century. In the past a small number of investors have been the victims of “boiler room” operations and the Nigerian e-mail scams, for instance. But pubic sympathy was not with them as they participated in high-risk ventures. The risks were astonishingly high that they were doomed to suffer sooner or later. Collapses of financial institutions in some countries have been few and far between but the danger is omnipresent. However, it now appears from judgments and media reports from different parts of the world that individuals who are otherwise averse to taking high risks may find it difficult and time consuming to recover their ill-advised investments in unregulated or not well regulated financial institutions. In some instances, even life-time savings are in jeopardy. There are also credible reports of individuals who have even committed suicides.
The very fact that an institution is regulated offers a degree of comfort and security. However it cannot be denied that even with the strictest of regulatory oversight financial institutions can yet engage in unethical conduct and fraudulent financial transactions. Northern Rock in the UK and H.I.H in Australia, for instance, collapsed despite being supervised by the regulators in those countries who were perceived to be among the best in the world. The liability of financial supervisors for investors’ losses is an area which needs to be explored in detail.
The existence of an effective regulator will have the effect of significantly improving compliance with the applicable legal, prudential and accounting requirements. With every crisis there is renewed emphasis on a post-mortem examination with a view to addressing deficiencies, regulatory gaps and limitations.
There are serious concerns everywhere that certain types of financial institutions that collect fixed deposits do not come within the purview of any regulatory body. Gaps in regulatory purview and oversight on the one hand, and duplication or overlap in exercising jurisdiction on the other hand are real concerns – these concerns led a few years ago to a recommendation in several countries for the creation of a ‘Single Financial Regulator’. The fact that UK did not find that experiment successful resulted in draft legislation not being proceeded with in some countries.
In the wake of every financial crisis or collapse of a financial institution, corporates and individuals tend to withdraw investments and plan to invest funds in what is perceived to be relatively safe investments or institutions. Premature withdrawals, even when permitted, are generally at a loss to the investor as the penalties imposed can be substantial. ‘Too Big to Fall’ is a myth.
The standard advice which financial advisers give is that maintaining investments in financial institutions that are well regulated is relatively safe; hence premature withdrawals should not be the norm.
Financial crises within institutions generally occur due to fraud or imprudent or illegal or unethical investments. The failure to institute proper risk management and internal control systems, lack of proper supervision and audit procedures and the absence of a culture of good governance facilitate and fuel such crises.
Several measures are possible to ameliorate the current situation and provide a greater degree of comfort to investors and prospective investors. Seven such measures are listed below:
- Introduce a system of guaranteeing deposits in regulated financial institutions. Such systems exist in over 25 countries such as the UK, US and Singapore. Maximum threshold limits guaranteed vary from country to country and these range from a high of US$100,000 to a low of $12,000. Other conditions too vary.
- Mandate the systematic use of credit rating. Credit Rating Agencies themselves need to have proper governance structures in place to ensure independence and transparency and employ well qualified professionals. Instruments that have a poor rating should not be offered to the market unless full disclosure is made of the inherent risks – these risks must be described in a language which anyone could comprehend. In 2014 Standard & Poor’s lost its appeal against a landmark court ruling in Australia, which found the credit rating agency misled investors by giving AAA ratings to toxic financial products that lost almost all their value.
- Ensure that risk management and internal control systems and anti-fraud policies are in place in every financial institution. Through independent audits, the effectiveness of these systems and policies must be monitored at frequent intervals. Compliance manuals must be updated at frequent intervals. Financial institutions must have an in-house “Anti-fraud Policy” in place. Whistle-blowing must be encouraged with necessary legal safeguards and immunity.
- Regulatory bodies must review their legal framework and operating guidelines. Regulatory gaps must be identified and necessary action taken to amend the legislation. There must be a fast-track procedure for the determination of claims through the judicial system and the institutions of Financial Ombudsman and Insurance Ombudsman.
- A culture of good governance must be fostered. Independent or non-executive board directors must understand their role. Some assume that they are obliged to be part of the cheering squad of the majority shareholder directors and refrain from commenting or questioning management, in the event should such questioning displease the majority shareholders. The following judgment from Malaysia affirms the fiduciary duties of the board and the role of the non-executive directors in very precise terms: per Ramly Ali J: “… Even, assuming that the plaintiff is a non-executive director, nevertheless he is still a director in the eyes of the law and his roles and duties are governed by the Companies Act 1965 in particular, s 132. Furthermore a non-executive director is entrusted to look after the affairs of the company and to keep a close watch on the company’s managers and other directors in order to safeguard the investment of shareholders.” Board papers must be made available in time for a detailed study prior to board meetings and concerned directors must have the unfettered discretion to clarify and remedy matters that might otherwise place the company’s existence in jeopardy.
- Consumer or investor education must be promoted. There should ideally be a system, as in Singapore, to regulate financial advisers. These advisers should be able to interpret published audited accounts and to comment on the financial health of deposit-taking institutions. Consumers should be advised to spread the risk – inherent in any form of investment – by diversifying their portfolio of investments. They should seek additional information from institutions that offer unusually high rates of interest or have a poor credit rating for instruments. There must be clear guidelines on advertisements and promotional materials.
- Professional bodies must be encouraged to be set up to give independent advice on loan restructuring, mergers and acquisitions, etc. Customers are sometimes handicapped when they attempt on their own to negotiate restructuring loans as financial institutions have well trained negotiators and recovery agents who do not give room for much flexibility. The case for restructuring becomes much stronger with a new business plan which demonstrates how cost cutting measures will result in a healthy balance sheet.
In 1776, Adam Smith stated in his magnum opus The Wealth of Nations that since directors of companies are managers of other people’s money than their own, one cannot expect them to watch over it with the same degree of vigilance with which the partners’ in a private business frequently watch over their own money. Directors and management of financial institutions that handle the public’s money must now surely know that the bells toll for them as well and that other people’s money must be handled with the same degree of vigilance they exercise over their own money.