Fin-economics revisited

September, 2015

Fan LiJi Ran

Finance relates to the art of government in ancient China,and is a philosophical matter in ancient Greece

Comments :

• Guan Zhong: “let merchants livetogether […] investigate the price andstock of goods”

• Shan Mo Gong: “if your people losemoney (after a devaluation), they willleave and threaten your dominance”

• Fang li: “regulating prices is good forthe market and to lever tax”

• Aristotle: without the framework ofvirtue, prosperity leads to vulgar pleasure

Aristotle

715 - 645 BC ~520 BC 322 BC

Shan MoGongGuan Zhong

Philosopher

Politicaladvisors

Market Money Stability

Virtue andProsperity

436 - 448 BC

Finance is the eldest daughter of economy but has distanceditself from humanities to join the exact science league

Comments :

• Economy as we know it today wasborn in the 19th century

• Three factors contributed to thedecline of the moral component

− The emergence offormalization (Maths)

− Positivism

− Moral was seen as preaching(religious)

AdamSmith1

Aristotle322 BC

Natural sciences

Moral Sciences

EconomicsMaths

Psychology, Geography …

Justice, equity,religion

18th century(mercantilism)

13th centuryScholastic economics

20th century(positivism)

Finance

1. The publishing of the « Wealth of Nations » in 1776 is often considered the date of birth of modern economics.

The [ abridged ] list of Western financial andaccounting scandals is quite long

Medici Bank (1494)

Mississipi Cie (1720)

South Sea Cie (1720)

Overend (1866)Fried. Krupp AG (1873)Dantbank (1931)

Allied Crude VegetableOil Refining Cie (1963)Herstatt Bank (1974)

Texaco (1987)Qintex (1989)Polly Peck (1990)

BCCI, Nordbanken (1991)Carrian Group (1993)Barings Bank (1995)Bre-X (1997)LTCM (1998)Equitable (2000)

HIH Insurance, PGEC,One.Tel, Worldcom,Enron, Chiquita (2001)Kmart (2002)Adelphia Com (2002)

Arthur Andersen (2002)Parmalat (2003)MG Rover (2005)Bayou Hedge Fund (2005)Refco (2005)Bear Sterns (2008)Northern Rock (2008)Lehman, AIG, RBS (2008)Washington Mutual (2008)ABN Amro (2008)Nortel, Anglo Irish (2009)Arcandor (2009)Schlecker (2012)Dynergy (2012)Banco Espirito Santo (2012)Tesco (2015)

Bardi, Peruzzi (1343-44)

Banco Ambrosiano (1982)

As an example, the Tesco accounting scandal reveals thequiet nurtering of a predatory financial culture

Recent and classic misbehavior case …

• The Tesco accounting scandal is a classic for whatappears a case of « cooking the books »

• Tesco chief executive, says he has discovered thatprofits for the six month to the end of August wereoverstated by £263 m due to the « acceleratedrecognition of commercial income an delayed accrualof costs ».

• Tesco was boosting profit by deducting cash fromsupplier’s trading account or extending payment dateswithout notice

• Tesco also started charging £ 30 per product forsuppliers to keep their products on eye-level-shelves

This type of behavior is nurturing a predatory financial culture

The case was uncovered after a whistleblower approachedTesco’s General Counsel

A thin line from dodgy practices to fraud

• A whistleblower, and staff member, approachedTesco’s General Counsel to tell him that somethingwas array in Tesco’s accounts

• Since the Enron scandal, aggressive accounting is onlyaccepted within clear and rather strict limits

• The market reacted to the announcement and Tescoshare price felt by 10%

• A number of British institutional investors have signedup with lawyers to pursue compensation for lossesrelating to the supermarket’s profits overstatement

• An investigation of the Serious Fraud Office (SFO) isgoing on and will have a material impact on the firm

This type of behaviour is nurturing a predatory financial culture

This event has resulted in serious consequences for Tesco:A loss of £ 20 Bn value since 2013

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Market Cap. : GBP 15.2 BnHigh-Low loss: GBP 20.1 Bn

Scandal announcement

SFO investigation

Aversion to sure risk is a major problem that lies at the heartof every MNC or financial institution

Rogue Traders :

• Nick Leeson (Barings, 1995): USD 1.3Bn loss leading to the bank collapse

• Yasuo Hamanaka (Sumitomo, 1996):USD 2.6 Bn loss

• John Rusnak (Allied Irish Bank, 2002),USD 691 m loss

• Chen Jiulin (China Aviation Oil, 2005)USD 550 m loss

• Jerome Kerviel (SG, 2008) USD 5.5 Bnloss

• Kweku Adoboli (UBS, 2011) USD 2.3Bn loss

People on a « special mission » can quickly lose sense ofcommon sense and basic ethics

Comments :

• The importance placed on a “specialmission” compared to rules is a suresign of danger

• Magic is referring to supernaturalcapacity to beat the odd and distancefrom reality

• One can conclude that he has completeruling power on deciding what isacceptable or not

• It is the equivalent for finance of whatpilots call “spatial disorientation”

« We are doing something special. Magical. Itisn’t a job – it is a mission. We are changing theworld. We are doing God’s work. »

Jeffrey Skilling, former CEO of Enron

Sound finance is only based on free market economy, and ithas to be guided by an ethical framework and the rule of law

Comments :

• Finance needs marketeconomy to work properly

• Market economy works on acertain set of conditions

• When those conditions arenot met, finance mechanismsare disfunctional

• This does not mean thatoperations are impossible

• But they come with a muchhigher risk than perceived:this impact pricesTrustAtomicity, Fluidity,

Mobility, Homogeneity,Transparency

Over-simplified accounting creates a « tunnel vision » on thevalue of a hidden production factor, often unaccounted for

Oversimplified accounting

Assets Liabilities

Comments :

• In spite of its complexity, the accountingsystem does not capture the value of thecommon good in the production process,and treats it as an exogenous factor

• However intangibles assets are alreadypart of the balance sheets, but there areno intangible liabilities, only potentialliabilities (usually unconsolidated)

The common good is a production factor which is never accounted for butmandatory for the sustainability of the economy

As a starting point, the management of sovereign ALM riskhas been over-simplified to a GDP / Public Debt approach

Comments :

• NNW captures the real country wealth, areserve available to invest in the future. Itis the difference between Total Assetsand Total Liabilities

• Total assets are not only monetary assetsbut also the common good including lifesupporting assets

• Total liabilities are the private andsovereign debt plus the remedy cost todamages caused by human activity to“life” supporting assets

• GDP often used to measure wealth usesvalue added flows only, and sometimesmisses important ones (e.g. unreportedfin. transactions)

Net National Wealth - NNW

NNW surplus

Assets Liabilities

The purpose of economic development is to prepare for abetter future worldwide

Comments :

• (a) stands for total tangibleand intangible assets(excluding G)

• (g) stands for the commongood stock

• (l) stands for liabilities, and(lp) for potential liabilities

• THW is the consolidation ofall NNW

• Must be consolidated for allcountries, to calculate a worldconsolidated picture

CommonGood

LiabilitiesAssets

NNW = a + g – (l + lp)

Net National Wealth acts as a monetary and nonmonetary capacitor to prepare for our future

In the 21st century, the main purpose of finance is to act as a« progress storage system » to prepare for a better future

Comments :

• Qf is the expected productionat the (inter)national level

• min is, minimum of the sumof individual expectations asa floor (> 0)

• T stands for individual andcollective talents, (previouslyL)

• K stands for accessiblecapital

• G represents the commongood (factor) needed for theproduction

Talents CapitalFuture

Qf (min is) = c. Tα . Kβ . Gγ

Labour CapitalProduction

Q = c. Lα . Kβ

Classic Cobb – Douglas production function

UCD - Updated Cobb Douglas production function

Common Good

CSR is a regulating mechanism, it helps keep the system’sat the desired set point and facilitates smooth evolution

Promoting a CSR culture emphasizes the importance of managing properly earthlife supporting assets

Sustainability,Shared responsibility

Socialism,Market economy

CSR

Comments :

• CSR is a major enabler fortransforming the economic growthmodel

• CSR helps mitigate business risksand strengthen corporategovernance

• CSR is seen as a powerful tool toenhance corporate brand

• Creates Shared Value (CSV), nowthe ultimate frontier for CSRpractitioners

Olivier CoispeauMaverlinn, Founding Partner

www.academia.edu

Leading a world of change, together