A brief introduction..

First words to explain why.

I have created this blog to share thoughts and experiences. I am glad if it helps other managers in their daily struggles. I am not so ambitious though, it can remain a place to simply read about those thoughts and experiences, or just a personal diary.

Finance is the main topic, yet the aim of this blog is indeed to discuss much more. It actually aims at discussing many different aspects of business management, leveraging on what I have seen, faced and learnt in my professional adventures.

Somehow it takes inspiration from the metamorphosis that happened in my life before and after entering the “bloody” field of finance (I had nothing to do with that earlier, my career started in HR management and before I was a mariner!). It started as a normal professional field, it actually changed my life. It gave me the opportunity to develop aspects that are not necessarily related to finance, to live situations that I would have otherwise not lived, to meet people I would have otherwise not met.

That’s why the stairs. I would not describe finance like Wikipedia would do (anyway Finance means plenty of things – markets, services, products, management, performance, decisions, investments, debt, house, life, job, savings, etc.). I would rather describe it like a web of stairs, full of people going up or down.

Apparently we chase money. In reality we chase much more.


Keep reading if this teases you.

Home page picture: taken from the 23rd floor of the European Central Bank building in Frankfurt (DE).

‘Blind pride’, financial audit and.. fraud

Biggest financial collapses in history came from fraud. Most of them (as not proven for all) from governance. One of the most emblematic was in Italy, in 2003. A famous multinational company operating in the food processing collapsed, after a hole of billions was discovered. Do you know the (unofficial) story of how the hole was discovered?

It was probably a very normal working day for an Italian junior auditor. Wake up early, quick breakfast and run to the client’s headquarter. Probably as a first task of the day, the senior asked the guy to check all confirmation letters received from the client’s counterparts, during circularization procedures.

One of those was a fax confirmation. It was supposed to come from a bank in the US, confirming an account balance of around three billion dollars, held by the company. The guy, who was awake (and smart) enough, paid attention not only to the confirmation of the numbers but to the sender’s details as well. Those very little details that you can hardly read at the edge of the sheet. He was expecting to see an US fax number, obviously. It was an Italian number, instead. It is quite easy to imagine how the scandal exploded afterwards.

I do not know if this story is fully true, however it gives a good representation of how things can easily go wrong when business managers feel invincible. What I call the ‘blind pride’ , is often the reason behind financial collapses in the last century. Other recent examples show similar attitude. In 2001, a colossal accounting fraud was discovered in the US and led to the bankruptcy of a major multinational group operating in the energy sector. As we all know, the biggest recent collapse happened in 2008 again in the US, few months after the CFO of the group proudly said that risks related to subprime loans were well addressed. Even more recently, in 2014, a major international financial group collapsed, few weeks after his Portuguese CEO proudly published his The last banker book. Many other examples exist, but I will stop here, to focus on some specific aspects.

In the initial case I mentioned, the fraud was discovered by the external auditor. Actually, as investors, we would expect the auditors to be there exactly for that. In reality, external auditors have really limited power to detect fraud and basically no chance to prevent it. There are several key issues behind this.

The first issue is responsibility. Without entering into specific details and text, if you read the International Standards of Auditing (ISA), you will notice three things: a) the ISA specify that the responsibility of preventing fraud stands, first of all, with governance and management; b) the ISA state that auditors have the responsibility to obtain reasonable assurance that financial statements are not mistaken; c) the ISA admit that there are unavoidable inherent limitations and that in case of fraud the risk is higher. Basically, in case of fraud auditors have very limited responsibility and they become somehow victim of that fraud like all other stakeholders.

Because of this limited responsibility in case of fraud (unless colluded), audit procedures on fraud are very limited too and, normally, the financial audit is conducted on the assumption that the risk of fraud is low.

Another issue is that audit procedures are very standardized (as defined by the ISA). This makes easier any plan to make fraud without being caught by the auditors.

A third issue is that auditors’ responsibility and mandate is in relation to the financial statements. This is again a limitation, as any decision, transaction, operation becomes relevant to them only if and when it affects the accounts. Financial statements are a backward looking window to the entity’s activities. Audit comes afterwards, therefore quite late. Moreover, even after so many scandals, the importance of financial reporting is still much undervalued. Most of the stakeholders do not care about financial statements content. They are not even able to properly read it and understand it. Rating agencies do analyze financial statements and company’s activities in detail, it seems not sufficient though (see 2008). Same thing for local regulators and authorities, they do have quite much power to inspect company’s operations, but the frequency and magnitude of fraud scandals shows that something is indeed missing. Despite the regulatory burden, on banks in particular, got much heavier in the last decade.

The biggest issue is independence. Despite subject to strict rotation and independence rules (e.g. the auditor must change after few years and cannot provide to the auditee other services not related to the audit mandate), the auditee selects and pays his auditor. Moreover, once the audit mandate ends, the auditee becomes a potential (or obvious) client for all other services.

Audit firms position in a competitive environment is therefore unavoidably delicate. In this context, in front of huge responsibilities, they have almost no power to challenge governance decisions and put their honesty in doubt.

Knowing all these aspects – the evidence that all financial disasters come from fraud and the fact that power is addictive and leads to the blind pride – I want to end this post with a question. Is it really impossible to strengthen auditors’ power and position in relation to fraud detection and prevention?

Wild west banking

With a certain degree of imagination, today’s situation in Europe makes me think about banks in the Wild West of America (with related romance, of course).

Initially, the only reason to put money at a bank could be to keep it in a ‘safe’ place, rather than earning a return. Basically, money had no other value than its physical value, and savers were just paying to keep their money safe.

In our XX century mind (unless you are a teenager), earning interest on money is – or was – obvious. Time value of money was clear to all of us.

Now, the persistent negative yields environment has turned everything upside down. It has also pulled prudent savers – who are any risk adverse (i.e. not investors) – back to the situation where they have no interest to put their money at a bank, but to keep it somewhere.

It is even worse. They pay both fees and interest, and the inflation is low but not negative. Deterioration of their wealth therefore goes fast.

Meanwhile, the digitization of money (and the AML and ATA regulations) makes the possibility of keeping it under the pillow unrealistic, while in the past it was a popular option (questionable, but an option).

Being a saver in our modern wild west may be painful then (if we ignore all other alternatives, of course).

I must admit, this analysis on individual savings is exacerbated. To emphasize the situation and make it more tangible, I used as example pure savers who prefer to see a slight constant decrease in their wealth, rather than facing any kind of risk and volatility. It is a quite extreme assumption and, moreover, banks that actually apply negative interest on individuals are indeed not many. However, nil interest on cash deposits is very common at the moment.

From a banking and business perspective, it is a real issue. European banks are suffering deeply from the persistent negative yields. While the ‘higher’ macroeconomic objectives to protect sovereign economies is indeed a priority, the banking system has serious difficulties to play its role of engine in those economies.

Margins are very thin and interbank deposits are expensive. Together with the CRD regulation and the post-crisis rules on NPLs and credit risk assessment, it puts banks under extreme pressure.

In other words, banks never really recovered from the 2008 crisis and the negative interests surely do not help. Lending activities and financial income remain weak and, in line with the EU economy in general, the banking sector is stuck at a very modest altitude, were the risk of hitting again the ground remains real. This is for Europe. Elsewhere (e.g. US) is different. However the risk of recession is more or less global and not only European banks may suffer from it.

Some corporates are also suffering, being obliged to hold deposits for liquidity risk management and paying negative (or nil) rate on it.

So, why this situation? The ECB squeezed the interest rates for two reasons: a) protect highly indebted European countries from the risk of default during and after the last crisis and b) stimulate the economic growth and the inflation in the EU.

Picture: 20-years chart on European official interest rates on deposit facility. Source: ECB website.

While the first objective was more or less achieved, the second is still far away. The temporary economic growth in some European countries between 2015 and 2018 was a kind of dead-cat bounce.

In 2019, the main European economies are stuck and the risk of recession is global (see trade war). Best performers are smaller economies (e.g. Ireland, Malta and Poland) that cannot balance the slowdown of the bigger players (e.g. Italy, Germany and France).

Picture: 2018 GDP growth rate by EU countries. Source: Eurostat website.

On the other hand, for some investors this situation is very juicy. Especially for those playing with leverage. For instance, when I did some RE investments in the last years, I kept insisting on floating rates for mortgage loans. Even when (2015) economists and asset managers were screaming out that the situation was unsustainable, that rates were going to increase soon, etc.. etc.. And even when (2018) the fixed rates where sometimes offered at a lower level than the floating (because of the difference between the short-term and the long-term curves). This is surely not a usual situation and can be a great opportunity for long-term investments.

Finally, not only those previsions were wrong, but now we are even talking about a “lower-for-long” scenario.

If a global recession materializes, also the investors (including myself) who enjoyed the low rates will eventually suffer, as one of the consequences of a recession is a decrease in assets value.

All this, highlights that there is a general stalemate in this situation and the way out from our wild west is neither easy nor close.

The Source

“FL is an international expert in corporate finance, business management, banking, financial markets and services.

Posts in this blog come from personal views and consolidated experience in the field.

The arguments treated derive from the professional path of the author, through different countries, environments and entities. These are financial institutions, multinational groups, intergovernmental organizations and other companies. Private or public, wide or small.

However, none of the posts directly points to any specific entity or the people involved.”