The Commerce Committee has held its first day of hearings on the Inquiry into Finance Company Failures. I have been criticised for chairing the inquiry as I was Minister of Commerce during the period that the finance company collapses occured – 2005-2008. They ignore that an incoming Labour government inherited what I’ve described as a regulatory wasteland and it took a considerable amount of time to bring our regulation up to international standards – starting from ensuring the Takeovers Panel had a code to enforce – through to providing appropriate regulatory oversight for registered exchanges (including rules around continuous disclosure, and much stricter rules around insider trading and market manipulation) – through to the Taskforce on Financial Intermediaries which I inherited as Minister after the 2005 election and the Review of Financial Products and Providers – which involved the release of 9 discussion documents in 2006 and the passing of 3 major pieces of legislation before the 2008 election. The current government has carried on this work and more regulation will be introduced as they work through the remaining elements of the reform package. The finance company failures have also highlighted deficiencies that were not apparent prior to the last government announcing decisions in 2007 about a fortnight before Bridgecorp collapsed.
This current inquiry is not designed to duplicate the work the previous government has done and the work the current government is doing. However I believe that my role as a former Minister of Commerce has given me some insights into the ‘what’s missing’ from the government’s current workplan. If anyone thinks that I am immune to the suffering of people who had no idea they were exposing their hard-earned money to the level of risk they were, then they don’t know me very well. Lessons must be learned about what attracted people to certain investments in the first place and whether we need tighter rules around what people are told about the nature of the risk they are taking. We have been accused of being populist by looking at tracing the money post failure and sheeting home responsibility to directors – but tell Mum & Dad investors that these things don’t matter when directors maintain their high life protected by family trusts and limited liability.
The role of the media has been interesting and will continue to be so. Read this story about the first day of hearings. In light of recent comments about the media being afraid to take on high profile individuals for fear of legal action I found it fascinating that not one media outlet reported the high profile politician who was mentioned in Professor Adams’ damning case study; nor the name of the high profile financial adviser the Crone’s referred to – even though such reporting would be covered by Parliamentary Privilege. More to come as the hearings continue!
This is going to be a very interesting inquiry.
Good work.
Sounds like you’re being castigated for not doing what needed to be done and the reason why you didn’t get it done is simply because you didn’t have time to do it. The political right have been attacking the last government like this for a while now.
All businesses, including sole trader, should have their books open to the public so that anyone interested in investing in them can see their exact position and their history. This information would probably have to be on a government server.
I am, I have no sympathy for them whatsoever. Their investment was for return on risk and the risk was that they weren’t going to get their money back. If they didn’t understand that then they should have kept out of the market.
Trusts and limited liability need to be banned because of this. The loss needs to fall on the right people.
The media is filtered in such a way so that people can’t make informed decisions.
Is it true that the Bolger or Shipley governments altered the arrangements for Finance companies having to produce audited results every six months to every 12 months . And this was specifically a case of a policy result being ‘bought’ by the finance industry
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Dalziel said…
…people who had no idea they were exposing their hard-earned money to the level of risk they were,…
I am in for government non-interference in the financial markets, it is true that markets have failed, but so what? It is suppose to be like that (succeed & fail at different stages).
Anyway I want to point out the beast called risk. AFAIK, the trained financial advisors have limited knowledge of managing risk. Usually, they don’t quantify risk, when they advise their clients. They often describe risk in terms of qualitative nature (ie, non-quantifiable), which such description becomes subjective, meaning advisor A, will have a different qualitative risk attach to say Bridgecorp compared to another qualitative risk evaluation from advisor B.
End-users need a single number for quantifying risk, which is easier for them to grasp rather than going through pages and pages reading about the description of a qualitative risk evaluation of a company. Users are more likely to get confused in trying to read pages & pages of qualitative risk evaluation rather than a single number that states clearly the level of (quantitative) risk attached to an asset, such as using VaR (value at risk) or GARCH or any of those advanced models. These risk evaluation techniques are not perfect (so as any other financial evaluation models), but they give some rough estimations about the level of risks that investors face.
I was shocked to find out in a discussion at Bruce Sheppard’s blog, that only one person (likely to be an academic) who has heard or know what GARCH risk/volatility evaluation is about. The rest of them , including lots of fund managers who frequented Bruce’s blog, never heard of it.
IMHO, the training of financial advisors is clearly inadequate (not upto a very sophisticated level), but that doesn’t mean I support a government mandate regulating them, because I believe that markets will work on its own, sure, there will ups & downs but in the real world it is suppose to work like that. I also think that BCom and may be MBA to some degree are still not advanced enough to equip those financial advisors to managing risks better.
A group of econo-physicists have come to criticize the level of knowledge that are being taught to finance/economic students as insufficient. Their recommendation (cue & pasted below) is:
I therefore suggest that the economists revise their
curriculum and require that the following topics be
taught: calculus through the advanced level, ordinary
differential equations (including advanced), partial
differential equations (including Green functions),
classical mechanics through modern nonlinear dynamics,
statistical physics, stochastic processes (including solving
Smoluchowski-Fokker-Planck equations), computer
programming (C, Pascal, etc.) and, for complexity, cell
biology. Time for such classes can be obtained in part by
eliminating micro- and macro-economics classes from the
curriculum. The students will then face a much harder
curriculum, and those who survive will come out ahead.
So might society as a whole.
From the paper: Response to “Worrying Trends in Econo-physics”.
I agree with one of the coauthor of the paper above (Prof McCauley), in that economic/finance departments & schools should raise the bar and the entry level for candidates enrolling in those courses.
Disclosure : I write software products in this domain (ie, in quantitative finance), so I am not advertising my software products here in this post, but just wanting to give an opinion about the financial markets.
FF
That sounds nice in our perfect theoretical world – but the issue with modelling risk is estimation of distributions. There is never sufficient data available to estimate risk as you suggest. I see you qualified your claims, but you are seriously deluded if you think VAR or Garch estimates can provide meaningful predictions of future, unknowable market risk. If nothing else, re-read When genius failed or Talebs Black Swan.
And you overlook the major problem with the whole finance company debacle which was lack of disclosure. Any analysis based on the accounts and information that finance companies disclosed would be pointless – they did not and were not forced to fully disclose some of the crappy prcices they were engaged in.
In my long history in financial markets I have seen plenty of model driven operations blow up – from the arbitrage desk at at Salomon, to Long Term capital to of course the whole MBS fiasco of the last two years.
Models can only ever provide an additional subjective input into a more holistic approach.
But seriously, the first steps needed in NZ are really really simple:
1. Full disclosure required with realistic criminal liability for not complying
2. No limit on creditors claiming back previous dividends and salaries for directors of failed companies
3. Any director of a company that fails and owes money to creditors automatically banned from any directorships for 3 years
4. More activist Securities commission and companies office than the pathetic toothless shells we have at the moment. When is the last time a director of a high profile failed company was pursued for trading while insolvent? Look at all the recent examples of that from finance companies to christmas hamper companies.
What ever gave you the idea that they were trained? Anyone can call themselves a financial advisor.
As Keynes, Minsky and a few other economists that have been either ignored or misrepresented (Keynes was misrepresented) it’s not risk that’s at the centre of economics but uncertainty.Nobody can predict the future.
Go read Debunking Economics by Steve Keen which will give you more information on why the present economic paradigm doesn’t work.
gomango said…
but you are seriously deluded if you think VAR or Garch estimates can provide meaningful predictions of future, unknowable market risk. If nothing else, re-read When genius failed or Talebs Black Swan.
As I said, that there are shortcomings in VAR and Garch, but quantifying is better than guess work. Standard economic models (or neoclassical economics) are all based on (thermodynamic) equilibrium, such as GARCH, Black-Scholes, DSGE (Dynamic stochastic general equilibrium), CAPM, APT, Fama-French 3-factor model and so forth. I am aware that NZ Treasury (and may be NZRB) are using DSGE. We now know that the assumptions that went into the formulations of these models were wrong, because the market doesn’t actually sit on an equilibrium state long enough (ie, there is no stable equilibrium point or regime at all) to justify the correctness of these models. If there is no equilibrium or it doesn’t exist, then these models are wrong (in other words I prefer to use the physicist’s terminology or description – the models are not generalized enough). It means that they’re not completely hopeless, but they’re incomplete. It is synonymous to newtonian mechanics/physics. We know that it is not generalize enough (ie, it failed to explain physics of the small, ie, quantum mechanics and it also failed to explain the physics of the large, ie, general relativity), but hey, we use it in our daily life to design cars, building structures , industrial machineries, and everything else around us. It’s only problem is that it is not generalize in which more generalized theories like quantum mechanics & general relativity have been proposed to supersede newtonian.
Sure, GARCH, CAPM, Black-Scholes are not generalized models because they were based on a simplistic and wrong assumptions of the market (ie, the market is supposed to be in stable equilibrium but in reality it is not), but they’re still useful. This why econo-physicists have called on economists to scrap or rewrite their curriculum, because it is littered with unworkable models based on false and unrealistic assumptions about the markets. The RiskMetrics Group (NYSE listed and an offshoot of JPMorgan), still uses GARCH. RiskMetrics risk analysis software system is popular with financial institutions and I am not sure whether they have updated their model into a more realistic powerlaw type model or not and if they don’t do it soon, someone out there will provide that as competition to them. (Hehe, may be that’s me).
Taleb is basically saying what econo-physicists have been saying. I haven’t read his book although I have read some of his academic papers, even I have implemented (software-wise) his option pricing models. I already knew what his book title is about, so I didn’t feel that I should read it. The black-swan is a problem that has been known in physics for decades, which is also known as Power-law (extreme and rare-event probability distribution), which are properties that exhibit by any non-equilibrium system (financial markets, climate system, cellular bio-molecular processes, etc…). It is only recent in the last 2 decades or so, that economists became aware of them, because the (real) markets exhibit power-law (non-equilibrium) rather than normal or bell-curve (gaussian or equilibrium). There are more recent publications in the literatures that attempt to model financial risk in a power-law framework (which is more realistic) than in a traditional bell-curve manner (unrealistic) as it is commonly used today. An excellent opinion here:
Econophysics and the Current Economic Turmoil
What I have developed into my software are both economic standard equilibrium models plus econophysics non-equilibrium models. Since standard economic models are static (again , it is unrealistic since the market is dynamic), I have also developed dynamic risks models (which are realistic), ie, the models are incrementally updated over time to reflect reality.
The major reason for failure of Long Capital and similar hedge funds can be attributed to the (unrealistic) equilibrium models they used (a major factor), plus some other minor reasons and 2 major shareholders at Long Capital were economics Nobel laureates Prof. Merton and Prof. Myron Scholes, which Taleb had called to ban Prof. Scholes from any involvement in the hedge-fund industry. Taleb has also appealed to the King of Sweden over recent years to scrap the Nobel awards for economics because current economic theories are unworkable. Taleb is not a physicist by training but now he works with models originated from physics (adaptive complex system’s dynamics – application to financial markets).
On the issue on regulation, I am against it. Let the industry police themselves, such as they can establish their own regulatory body to make everyone compliant about their own drafted standards. Any cowboy who chooses to not abide by such standards, then it is up to the investing public to choose in their own volition whether to use the services of those cowboys or not. It is buyer beware. For those who thinks that more regulations will solve the problems are deluded. How many financial crises have we seen since the collapsed of the late 1920s and early 1930s? More regulations were imposed then and it didn’t stop or prevent crises afterwards as we have seen in recent years. More regulations will not stop any more crises in the future.
I agree that frequent or continual disclosures are needed from finance companies, but again, that should be left to the industry themselves and not government regulations.
Without sidetracking into model analysis, the gist of the problem is encapsulated in your final comment. In a world of honest practitioners of course full self disclosure is enough. But if there is no sanction for dishonesty then investors are at a massive informational disadvantage. I would generally sit on the same part of the economic spectrum as yourself, but in the absence of sanctions on criminal activity (the right role of government) then retail investors, even if they behave rationally don’t have the ability to see thru the the (unfortunately) legal but not ethical behaviour of so many instos in NZ.
Interested in home grown portfolio software. Have a need for front office optimisation and risk management software, and am about to buy SmartFolio – if you have a better homegrown solution I’d be very happy to throw it into the mix. You can email me at gomango64@gmail.com with details.
Draco T Bastard All businesses, including sole trader, should have their books open to the public so that anyone interested in investing in them can see their exact position and their history. This information would probably have to be on a government server.
What an appalling idea such a breach of privacy would be. Its none of your business how much my business makes, Draco.
Most small businesses are not inviting the public at large to invest in their businesses.
I am, I have no sympathy for them whatsoever. Their investment was for return on risk and the risk was that they weren’t going to get their money back. If they didn’t understand that then they should have kept out of the market.
No doubt a number of investors felt that contracting an investment advisor compensated for their lack of expertise. In the same way that we contract a doctor to compensate for our lack of expertise in appendectomies. I guess if we don’t understand appendectomies, we should keep out of the hospital.
Trusts and limited liability need to be banned because of this. The loss needs to fall on the right people.
It would certainly make it difficult to find anyone willing to put their hands up for Board positions or Trustee positions. And strongly discourage entrepreneurs from being entrepreneurial.
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