Saturday, October 23, 2010

Risk ... maybe increasing faster than corporate profits

Dear Colleagues

Risk is not an inconsequential matter ... the failure to understand risk brought the global economy to the brink of complete disaster with the financial sector meltdown, and only some exceptional moves by government and central banks in the US and around the world kept the system working ... albeit on life support. What lessons have been learned ... if any?

I learned accountancy in an era when audit certification required an opinion about the reported financial results being "true and fair" and reflecting the records of the company which had been kept according to prevailing standards ... I forget the exact words ... but the concept was simple ... the reported results were right and could be relied upon. Behind the accounting there was a simple set of principles ... accountancy principles ... which meant that ALL assets and liabilities were included in the accounts and the reporting. This required a judgement call by professional accountants as to what had to be included ... not simply rules that were subject to lobbying and manipulation ... and one liability was "contingency" ... in other words "risk"!

Perhaps the biggest liability that now exists in the modern economy and in the typical balance sheet of a big corporate organization is risk ... and modern accounting tends to ignore risk as a liability to be recorded ... until it is way too late. Modern accounting law, rules and regulations argues against including something like risk in the liabilities of the organization ... yet it is fairly clear that very big corporations are now exposed to huge risks AND in broad terms the top management does not have a very clear idea of what these risks are.

The use of complex models to make decisions in the financial sector is clearly widespread ... and maybe there is a high and unacceptable risk associated with this practice. The CEO of CitiGroup testified, I believe that the models being used were never run with a house price decline of more than 15%, so it came as a surprise when house prices declined by more than this and the sub-prime mortgage disaster burst on the scene. What risks are implicit in this approach to managing a business, and the business being so huge that mistakes can break the world economy?

It seems as if BP's top management was caught flat-footed when their oil well in the Gulf exploded and a huge oil spill followed ... they could have been prepared but top management never allocated resources to engineers to be prepared ... they took a risk that they would not need to be prepared, and did not prepare ... and were unprepared. The profit hit was huge and the damage to the environment and society maybe bigger! Big initiatives have the prospect of huge profit ... but the risk associated with these huge initiatives should be put into the accounts as tangible contingencies.

It seems that the telecom sector is going in the same direction. I think I am right ... Verizon just reported record profits on top of higher revenues and lower costs. But while this was being reported my own personal Verizon service was malfunctioning ... FIOS TV, telephone and Internet ... all not working! The problem was reported Tuesday ... and today is Saturday, and the problem is still not fixed. The maintenance crew seems to be tiny and the problems to be handled are considerable ... the system seems to have been cost-reduced almost to extinction. What risk does this represent for the company Verizon ... but more important, what risk does this represent for our society as a whole? Imagine what would happen if there were to be a substantial "event" that knocked out a big part of their network! How long would it take to get the system back into a functioning state again ... and yes ... could they do it? Maybe not!

Risk is going to be ignored as long as there are no metrics about risk ... and it is allowed that risk may be ignored in making financial reports about corporate business. Risk is quite small in a small organization ... but in very big organizations, those that are too big to fail ... the risk may be catastrophic. The trouble with modern money accountancy is that risks like this are "off balance sheet" and off the radar. How big these risks are is anybody's guess ... but I would expect that some of these risks are big enough to pull down the US economy or more. The idea that huge systemic risks are outside the prevailing system of metrics is disturbing ... in fact downright scary!

Peter Burgess

No comments:

Post a Comment