Short Selling Hygiene

Good to see the short sellers doing the regulators' work for them again - not that the authorities like it. 

Last week, Spain's stock market regulator called on the SEC and the FCA to provide information about short seller Gotham City at the same time as its dodgy target, Gowex, was declaring GC's fraud allegations to be "categorically false". But yesterday, Gowex's founder admitted to falsifying accounts for past four years.

It defies belief that short sellers should be able to find such golden opportunities amongst listed companies. 

Just goes to show that auditors still need to understand the nature of scepticism. And that regulators could benefit from hiring some traders of their own.

Dirty Data

Westiminster recently feigned shock and horror that the UK's coppers cook the crime figures. But Simon Jenkins says we've known for years that the numbers are meaningless and they should be banned as "they spread confusion and fear".

But 'plod' is not alone in mis-classifying, mis-recording, ignoring or otherwise presenting data in a way that suits himself. We've had many financial trading scandals where banks apparently had no idea of the exposures they faced, either because transactions were concealed or perhaps no one was looking hard enough - the global financial crisis was a function of poor due diligence.

A possible root cause of the problem is that humans are involved too early in the data collection and reporting processes. Rarely are we responding to the 'raw' data, as opposed to figures that have been 'gathered' and 'rolled up' through a series of other people's filters, manipulations and interpretations (which are often taken out of context). It's puzzling why regulators' systems don't receive a feed of the actual trades straight from bank trading desks - or from peer-to-peer lending or crowdfunding platforms - rather than relying on periodic reporting of summary data.

Maybe GCHQ can help...

At any rate, we should focus more on 'clean' mechanisms for capturing and presenting raw data rather than someone else's interpretation of it.

Image from TraceyNolte.
 

Bank Off Scotfree

See Chapter 5.

Numerous questions tumble out of the cracks of the FSA's report on the destruction of Bank of Scotland: where is the review of the FSA's ARROW visits (as for Northern Wreck)? who were the key participants and their highly paid flunkies? Were any of them also responsible for the bank's £20m worth of bad attitude to complaints, by any chance?

For the tuppence it's worth, the report says that from 2006 to 2008:

"(1)  there were serious deficiencies in the control framework, which meant that it failed to provide robust oversight and challenge to the business;
(2) there were serious deficiencies with the framework for the management of credit risk across the portfolio which meant that there was a lack of focus on the need to manage risk across the portfolio as a whole;
(3) there were serious deficiencies in the distribution framework which meant that it did not operate effectively to reduce the risk in the portfolio; and
(4) there were serious deficiencies in the process for the identification and management of transactions which showed signs of stress which meant that they were neither identified promptly nor managed effectively."

And there were:

"targets which incentivised ...:
(1) prioritising the development of relationships with and the facilitation of customers;
(2) increasing the appetite to lend;
(3) increasing the appetite to take on greater credit risk;
(4) fostering an attitude of optimism at the expense of prudence; and
(5) regarding risk management as a constraint on the business rather than integral to it."

Furthermore, there were:

"significant issues as to the quality, reliability and utility of the available management information which directly affected the effectiveness with which the risks of the business could be assessed, managed and mitigated."

And, finally:

"(1) Group Risk failed to conduct effective oversight and control of Corporate; and
(2) there were issues with the quality and scope of assurance work undertaken by Group Internal Audit."

The FSA's solution?

"In these exceptional circumstances, the most effective way in which to balance the need for deterrence and act in the wider public interest is to issue a public censure."

Desperate times call for desperate measures!

When Will Control Truly Shift To The Consumer?

For those engaged in the process of empowering consumers, 2012 is already a fascinating year. So it was timely that a bunch of us met at Ctrl Shift's "Explorer's Club" to try to map the timeline for when 'customer relationship management' truly inverts and firms finally acknowledge their customers control them. 

The output of the session is being converted into an 'infographic' that will be available as a reference soon. In the meantime, here's an excellent drawing that Joel Cooper produced during the session to reflect the various themes:

Bad Data In...

The IMF seems to be having a bad year. First it was accused of 'groupthink'. Then it was rumoured (again) to be considering Gordon Brown as its leader.

Now it's The Economist's turn to sink the slipper. It points out that the IMF's forecast of China's current-account surplus assumes a steadily depreciating yuan, and a widening surplus. That provides ammunition for protectionists to impose tariffs on Chinese goods. Yet China's current-account surplus has actually declined since 2006.

But let's not just pick on the IMF. In "Botox and Beancounting", The Economist also points out the cosmetic effect of US official measures of government debt, productivity and economic growth compared to European measures. "The snag comes if investors fail to grasp that official national figures can show the American economy in an overly flattering light."

Of course, none of these is an isolated incident. There are also fundamental problems in comparing corporate financial data, for instance, given differing accounting standards.

And we live in a world where auditors are still trying to figure out what "scepticism" means...

But we don't have a problem detecting bad data. Plenty of people warned others about what Madoff's fraud, for example, and investment analysts routinely uncover issues such as The Economist has reported. Short-sellers make this their business. No, as David Einhorn elucidated in "Fooling Some of the People All of the Time", the problem is how to give the same weight of publicity to the prudent interpretation of the data as is given to the release of the data itself.

The media and social media clearly play a significant role. But even if we create an Office of the Devil's Advocate, ultimately each of us must accept responsibility for thinking critically about the data we're given if we're to avoid making some big mistakes.

Image from TraceyNolte.

Snake Oil And The "Science" Of Liberty

A hat-tip to @rorysutherland, who drew my attention to a paper called "The Science of Liberty" by Paul Zak, self-styled "founder in the field of neuroeconomics" with the following tweet on 1 December :

"http://bit.ly/gMGr06 expect to hear a lot more about Oxytocin in marketing writings going forward. This is a good piece."

The paper purports to provide a basis for lighter financial regulation, but ironically points in the opposite direction. It was funded in part by the John Templeton Foundation, a conservative philanthropic organisation, whose President also supports "Let Freedom Ring", the lobbying outfit that also supports the "Tea Party"; and partly by the Gruter Institute for Law and Behavioural Research.

I hope I don't do Paul's reasoning any injustice, but I understand his thesis to be as follows (italics are mine):

• His research found that "a brain chemical called oxytocin (ox-ee-TOE-sin) is released when a stranger takes money from his or her pocket and intentionally gives it to another person in order to demonstrate trust tangibly... the more money the person receiving the trust-denoting transfer receives, the more his or her brain releases oxytocin. Oxytocin levels, in turn, predict how much the second person will reciprocate the first person; that his, how trustworthy she or he will be."
• This process is "nearly impossible to inhibit".
• However, 2% of those studied did not reciprocate, and "there is a technical word in my lab for these folks: "bastards (sic). Not people you want to have a coffee with... On the other hand, two percent isn't bad. It means most people most of the time are trustworthy, and the others can be identified with a slight bit of investigation."
• Participants go out of their way to punish moral violations in the market "when observers of ethical violations are in a position to punish the violators".
• As a result of these findings, Paul argues that "virtue is in fact the very foundation of trade... The market can be fabulously large if most people, most of the time, behave morally, and if their moral tendencies are supported by a legal system in which property rights are protected and contracts enforced."
• Accordingly, Paul asserts that "Economic systems that provide for freedom and limited oversight recognize human dignity and the desire for self-direction."  Such "economies are complex, adaptive, and evolving systems that need no controller. Just a clear set of rules that are enforced by some independent regulatory body."
• "A number of studies have shown that too much oversight crowds out our innate sense of virtue (Gneezy and Rustichini, 2000). A fine for every violation decouples transgressions from the moral violations to a "greed is good" justification. This is Enron and the like" [includes Ford (Pinto gas tanks) and USSR].
• In other words, the Enron scandal was created by overly intrusive regulation, and therefore we should have less of it.

Certainly at this last point the logical elastic band finally snaps.

Ironically, far from presenting a basis for lighter financial regulation, I'm afraid Paul Zak's research into the effects of Oxytocin shows exactly why people need greater protection from the snake oil salesmen, who understand it's effects only too well. The "bastards" are out there, and even two percent of the population means there are actually a lot of them. They can be tough to challenge, especially once they've generated a bandwagon effect. And other market participants are not always in a position to punish these rogues, at least not in time to prevent them doing significant harm - due diligence does not scale well. Finally, Alan Greenspan, former Chairman of the US Federal Reserve advocated light touch financial regulation for 40 years, and lived to regret it:

"In Congressional testimony on October 23, 2008, Greenspan acknowledged that he was "partially" wrong in opposing regulation and stated "Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity — myself especially — are in a state of shocked disbelief." Referring to his free-market ideology, Greenspan said: “I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.” Rep. Henry Waxman (D-CA) then pressed him to clarify his words. “In other words, you found that your view of the world, your ideology, was not right, it was not working,” Waxman said. “Absolutely, precisely,” Greenspan replied. “You know, that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.” Greenspan admitted fault in opposing regulation of derivatives and acknowledged that financial institutions didn't protect shareholders and investments as well as he expected."

As observed in Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism:

"...[T]the unvarnished invisible hand story, although right in a fundamental way, is wrong at the level of detail and approximation that is necessary to explain what we need to know about macroeconomics.

The old story about capitalism is correct: it gives us what we think we want. But capitalism does not act as its own policeman if we fail to watch over it and give it proper directions. It actively, competitively, seeks the most profit-maximising opportunities. Capitalism will follow such opportunities wherever they lead us...

If [we] are willing to pay for real medicine, it will produce real medicine. But if [we] are also willing to pay for snake oil, it will produce snake oil. Indeed, nineteenth century America had a whole industry devoted to fraudulent patent medicine."

Now, I'm no fan of the Nanny State. I don't believe regulation acts as a market catalyst. And I've written often in support of better regulation rather than simply more of it. It's also clear that the financial regulation spawned by the accounting scandals like Enron failed to avert the latest financial crisis, and is unlikely to avert the next without a fundamental change in the importance that we attach to wealth creation.

But this paper perhaps may serve as further evidence that regulation should be aimed at improving transparency at the point when people first engage with a financial service or its promoter. Simplifying products, documentation and disclosures is critical. Another tactic may be to move away from vertical to horizontal models for intermediation.

More limited oversight is not an option.