Review of Market Meltdown

The last few days have seen upheavals in the world financial markets. Lehman Brothers fell, Merrill Lynch was sold to Bank of America, AIG was bailed out and Morgan Stanley is looking for a rescuer. What are the lessons that we need to learn from these financial failures?

Financial companies, banks included, need much more robust systems to safeguard their assets, mainly financial assets, than a company with tangible assets would need. The system should provide for a periodical review and verification of advances and investments with a view to ensuring realisability and recoverability of investments and advances. Given the gargantuan size and geographic spread of operations, such verification is a tall order. The inevitable conclusion is that larger the size of financial institution, the more the chances that the ultimate controls weaken.
The value of sound tangible assets on the balance sheet of a company cannot be over emphasized. It is easier to determine the value of a tangible asset by letting it float in an open market where it is traded between knowledgeable people. It is not easy to determine the value of an intangible asset in the same manner. Value of intangible asset is more subject to fluctuations and is more often than not a matter of perception, than the value of a tangible asset. And perceptions take no time to change.

Good management practices, systems and accounting standards have a role to play in ensuring safety of the investors’ funds. However such role should not be over emphasized. A lot depends upon the character of people like top managers, directors, and to an extent, auditors, who are involved in maintaining systems. Only a naïve would believe that Lehman Brothers became insolvent in one day. The process of insolvency may have set in long before. Decay may have set in long before. Why then did the decay remain a secret?

The answer is: whatever the degree and amount of auditing, it is only the people at the top who matter. The knowledge gained by others is as much as these people provide. If the people at the top develop vested interest in any information desiring it to be in a particular manner, it is very difficult for an outsider to ascertain the truth about the information. We have necessarily to rely on trust and integrity of the people providing information. Managements should be bold enough to admit the setting of decay.

However, corporate policies are so much market driven these days that it is too much to expect a management admitting the decay in early stages. Most of the corporate financial policies are decided keeping the possible market reactions in mind. The lesson is that the truth is often guillotined.

When you part with your money in somebody’s favor by way of investment, you start running the risk. However, the whole financial system works on savings, investment and further lending and investment by financial agencies. Thus it is inevitable that when you save you have to invest. But the financial mess is a lesson telling you that big is not always the best. It is often the case that a good management in a small corporation gives better returns than a bad management in a large corporation.

Governments must take this lesson that it is dangerous to put so much financial powers in executives whose only stake is in their salary and play with the money belonging to others. Governments should strive to promote genuine democracy of the enlightened in financial corporations. There should be a flow of reliable information from the management to the investors.

Such corporations may though belong to the private sector, should be regulated by democratic principles. They can be brought under the purview of the Right to Information Act in a limited way in that the investors should have full access to the information, and denial of furnishing information or furnishing wrong or inaccurate information should be made punishable.

This lesson tells us that at the end of the day any investment is only a value held. Values are prone to change and when the values owed to people other than proprietors and owners exceed values held, the corporation could be in trouble. It is often the case that decline in values of assets is ignored, notwithstanding accounting standards mandating recognition of such a fall, while bestowing largesse on stakeholders by way of dividend. Corporations should not shy away from recognizing such a fall in the value of assets.

Corporations take most of the financial decisions keeping the market reactions in mind. And this makes it difficult for the truth to come out in the early stages.