The CEO cannot be expected to be an expert on everything. But he or she must be willing and able to get the fundamentals and pick up enough of the jargon to do what the chief executive’s job demands. Namely, the ability to:
● Ask the right questions, and
● Accurately evaluate the answers, leading to more questions.
When they are correct and to the point, qualitative comments which are com- plementing quantitative answers, are instrumental in picturing the company’s operations: one-by-one and as a whole. While analytical information on products and services is at the top of the list, financial analysis, too, has a key position in good governance, because:
● Its goals are the soul of the company’s existence, and
● The nature of financial information is pervasive, entering into every walk of organizational life.
Personality traits are also important. Above and beyond his or her other quali- ties, the CEO must be quick both in number crunching and in decision-making.
He or she should also assume full responsibility for all decisions made under
their authority. All these positive characteristics are strengthened through fair value management reporting.
The internal accounting management information system (IAMIS)3the company puts in place must provide consistent and comparable information elements.
One way to assure comparability is that all of the company’s assets are marked to market. Using both marking to market and accruals for assets and liabilities positions can give results that are uncoupled and misleading. As an example, take a balance sheet which shows:
Assets Liabilities
100 90 Debt
10 Equity
Over time, accruals still show 100 in assets, but marking-to-market may show 90 in assets, using capitalization as proxy. Because the debt has not changed, the equity is gone. The company has no more core capital.
This poses serious management challenges (not only problems to accounting), and brings into the picture the need for recapitalization. Short of this, the distance to default can dramatically shorten – and senior management must be immedi- ately informed about it, not at the end of the week, month, or year. The virtual bal- ance sheet provides the needed support for damage control and corrective action.
What about marking to market the liabilities? This is not in the books. Part of the difficulty of fair valuing the liabilities is that while a market for them exists, it is narrow. Some experts suggest using fair value in a way consistent with the mar- ket value of heavily traded assets of similar characteristics. But this is possible only in some industries. In the insurance business, for example,
● Ifit is possible to calculate the fair value of life insurance liabilities
● Thenit is feasible to use the same technique for the calculation of premiums.
In banking, derivative financial instruments, with which most big credit institu- tions are overloaded, may fall into this class. The same derivatives in the trading book of the financial entity may be classified as ‘other assets’ when in-the-money and ‘other liabilities’ when out-of-the money. The difference is made by the instrument’s market value (more on this in section 6).
This process, however, has its challenges. Trading positions in financial deriva- tives may be classical or exotic. What is by now considered classical derivative
financial instruments include interest rate swaps (IRS), currency swaps, forward rate agreements (FRA), foreign exchange forwards, options on equities, equity indices, financial futures, and more.
Exotic financial instruments are more novel and more complex. Therefore, they are less understood by market players and, quite often, have legal loopholes.
Options providing an example are: all or nothing, average strike, barrier, basket, binary, choser, nested or compound. Other examples are instruments connected to credit risk exposure, currency rate exposure, down and on, down and out, embeddos, knock-in, knock-out, lookbacks, one-touch, outperformance, path- dependent, preference, quanto, step-lock, synthetic time-dependent, up and in, up and out.
Many, though not all, of the exotics are tailor-made to the client’s specs.
Therefore, they are difficult to generalize and classify from a credit risk and mar- ket risk standpoint. Plenty of customized derivatives are today available or can be developed on request. Some are found in interest and currency markets; oth- ers are equity or debt related.
Because the trading environment of exotic derivatives is unstructured, fair valu- ing them is no easy task. This is, incidentally, one of the reasons why a ⫾4%
accuracy is acceptable with the virtual balance sheet. According to the Fermi principle, there is a good likelihood that derivatives would balance themselves out. The purpose is not to gain precision, but an acceptable level of accuracy accompanied by speed in:
● Management information, and
● Damage control, if the situation warrants corrective action.
The officers of the bank evaluating the appropriateness of portfolio positions, falling into an unstructured environment, must be fully aware of both counterparty risk and of market exposure. For this, they should be equipped with powerful means for risk evaluation as well as for experimentation – more than ‘What-if’ dis- cussed in section 2. The tools available to senior executives must allow them to:
● Become truly proactive, and
● Adopt a rigorous risk management culture.
It is preferable to provide senior management with interactive visualization, rather than cold numbers. A radar chart can be a first-class medium for communicating on-line information in selected crucial variables. The example in Figure 15.2
comes from an application which rated four different companies against one another in regard to six factors chosen to reflect quality of governance.
In conclusion, as the examples we saw in section 4 and in this section demon- strate, a virtual B/S based on fair value accounting is very important to regula- tors, bankers, financial analysts, and investors. If we understand the fair value of assets and liabilities, we can assess the worth of company stock. With that knowledge the balance sheet and income statement take present meaning, rather than reflecting slow changing data.