Tuesday 11 October 2022

Tax cuts and inflation not the only threat to the UK economy

 Derivatives have a bad name, star investor Warren Buffett having described them as "financial weapons of mass destruction". One exception looked to be the liability driven investment or LDI. Private Eye's In The City column explains that "LDI enabled pension funds large and small to reduce the risks from future liabilities by using derivatives". I must confess that I did not follow the detail, but the conclusion was that LDI has up until now done its job in normal financial markets, and even "if bond prices fell and there was a margin call for more collateral, this could be easily achieved by selling other assets to produce the cash. But that envisages time frames of days not hours, and that prices declined not cratered" - as happened after chancellor Kwarteng's financial statement. Hence the Bank of England's intervention last week and again today.  So LDI was just as risky as any instrument which has derivatives at its base, and pension fund managers are going to have to revise their strategies again.

But there is another Eye story which worries me more. There is a threat to the integrity of banks and probably large companies too as a result of iffy auditing standards.

In the run-up to [the 2008/9] financial crash, banks such as Northern Rock, RBS and HBOS hid billions of pounds in losses on loans until it was too late to do anything about them. Since then, internationally agreed accounting rules - heavily influenced by the Big Four accountancy firms that draw so much of their income from the financial sector - have barely changed. Currently, banks have to estimate what their losses on loans such as mortgages will be over the following 12 months, rather than what the total they won't get back really is. As it's easy to put on the rose-tinted specs and judge that default is at least a year away, the effect can be to conceal serious problems.

Some academics and investor groups have argued for action before it's too late again. They also say that the requirement under UK company law for accounts to show a "true and fair view" of a company's business overrides the specific 12-month rule and incorporates all reasonably foreseeable losses. 

Standard-setters are unmoved.

The Eye predicts doom "As interest rates soar and debt defaults loom while Liz Truss's government deregulates the City regardless".

No comments: