Subject: E2

Section: A2

Learning Outcome: A

Resource type: Article

Author: Peter Fullam

Title: Accountants and the Economic Crisis

Description: Economic Crisis

Article content

What has been the role of management accountants in the banks, regulators and national treasuries
caught up in the unfolding crisis? Accountants at the heart of many of these institutions have a duty to
speak out when the numbers don’t stack up

Since 2007, the Western economies have been shaken by the near collapse of financial markets.
Huge losses have been incurred affecting individuals, corporations and nations in a way not seen
since the depression of the 1930s.

The banking industry is on the point of collapse in a number of countries. Credit is constrained, there
is little economic growth and confidence is in short supply. Trust is a thing of the past. The threat of
unemployment is real for a growing number of people.

Why? Because the western world lived beyond its means for too long, and because individuals
indulged themselves with easy access to cheap credit. On top of that, the financial services industry
ignored the basic laws of prudence and common sense, and regulators did not intervene.

How did it happen?

Governments ran up ever-increasing deficits and, consequently, national debt levels soared as a
result of sloppy or populist policies, driven by the need to be re-elected.

Citizens seldom demand higher taxation or refuse handouts. Individuals had easy access to credit for
consumer goods and housing, and were encouraged to splurge on, for example, buy-to-let properties.

Individuals felt property prices would only rise and the sooner they purchased, the better – else they
would be left behind and lose the opportunity to make a killing. Their ability to borrow went out of sync
with their capacity to service the borrowings.

The advent of the euro created a vast supply of historically cheap credit and poured petrol on an
already blazing fire. The financial services industry facilitated the increasing provision of consumer
credit, and in pursuit of volume and market share banks competed in the provision of mortgages.

They loosened their lending criteria and, in some cases, used brokerages whose practices were
dubious. To create the capacity to lend, banks securitised groups of loans, sliced and diced them into
packages, had these rated by the rating agencies and sold them on to other institutions.

This in itself is not a problem – until the slicing and dicing becomes ever more complicated and
people fail to understand the underlying risk to which they are exposed. It’s a problem when rating
agencies apply a formulaic approach and don’t address basic questions of likely default in particular
scenarios.
It’s also an issue when one part of a finance house bets on the default of a security initiated by
another part of the same house but sold on to third parties. When buyers depend solely on a rating to
make investment decisions, rather than understand the instrument they are buying, it’s also a
problem.

The industry focused on sales rather than risk. Participants forgot their job was to facilitate trade and
industry, and became players themselves.

Many banks’ balance sheets became stressed as the relationship between deposits and loans
deteriorated, and reliance on short-term market funding grew. Some banks proved adept at moving
positions off balance sheets. Meanwhile, the regulators and central bankers said very little.

Everybody talked about growth. Nobody noticed the temperature rising before the inevitable burn-out.

The outcomes
The values of any non-cash assets individuals own have been reduced. Pensions, both personal and
corporate, were badly hit.

As a result, people close to retirement have suffered both reduced asset valuations and increased
cost of annuities. Deficits are common in many corporate schemes and employers are unable to
restore the reserves to the correct level. Anybody dependent on the state for their pension is aware
that it has not funded their rights and expectations, and that it wants to reduce its liability.

Credit has dried up as banks have had to reduce the size of their balance sheets, lost confidence in
their banking counterparties and become reluctant to lend except for short periods. Credit to the
consumer has been curtailed and repriced upwards.

At the same time, small businesses are being squeezed as their access to credit is diminished. The
US, UK and eurozone have intervened to nationalise or recapitalise their banks, as well as introduce
market intervention tools, including bail-out funds and bond-buying programmes.

These interventions cost money. The taxpayer has paid as bank losses have been “socialised” and
subsidised credit is provided for liquidity purposes.

The perception of sovereign risk has changed. Some states can no longer borrow because they have
propped up failed banks and run up unsustainable national debt levels. States have had to take action
on their deficits, which means more taxation but less expenditure.

This means less money for the consumer to spend, which has led to lower demand and higher
unemployment. This prescription will have to be taken for years until balance is restored.

Likewise, capital investment to increase capacity or improve efficiency in the economy has been
postponed. A downward spiral into recession and depression is a real risk.

Companies in most sectors generally behaved responsibly, got on with trading and didn’t participate
in activities outside the mainstream. This is reflected in their profitability and the quality of their
balance sheets. There are exceptions, however, such as the construction and development sector.

Risk and accountants

CIMA members in all sectors are trained to identify and assess risks to businesses or clients. We look
internally and externally, and we could fill an appendix with all the types of risk we encounter.

Some risks – civil unrest (army/police), utilities (power/water), transport (roads/rail), health (air
pollution) – are left to the state, but accountants are well placed to be vigilant elsewhere.

There are accountants working in countries’ treasuries. Surely they would check that the books
balance? Do we as citizens not look at our national accounts now and again? Evidently not.
There are accountants in regulators’ offices. Surely they can read balance sheets and see if banks
are over extended or identify over-concentration of risk, then do something about it?

Are there accountants working at ratings agencies? If so, how can they give sub-prime mortgages a
higher rating than some sovereign states?

There are accountants in the banks and brokerages who could see the concentration of risk in
particular sectors and the slackening of underwriting criteria, or who sit on asset and liability
committees and could identify funding weaknesses.

Surely when HSBC took over American sub-prime lender Household International in 2003 it had
internal accountants to do due diligence and external reporting? Yet within three years, HSBC was
nursing a multi-billion dollar loss.

Likewise, after Royal Bank of Scotland took over Dutch bank ABN AMRO in 2007 it had to be rescued
by the UK government.

There are many major institutions on both sides of the Atlantic that got it spectacularly wrong. How
could this have happened if accountants were doing their jobs properly?

The dilemma
What is wrong with us individually and collectively that we, without complaining or shouting stop, allow
our countries to overspend? What is wrong with us that we allow a financial services industry to
sleepwalk into a crisis?

We all stood by as inappropriate behaviour was rewarded – and the platform for commercial activity
shook itself to pieces. We did not show leadership through this crisis. Instead we followed like sheep.

We stood by as this great destruction of wealth took place. There was no public outcry from
accountants. I don’t remember any accounting body writing to The Financial Times to give an opinion
on anything in the recent past.

Reflection
The Holy Grail of economics is sustainable growth. It is obvious to the man in the street that our
behaviour of the past decade was not, and could never be, sustainable. One can’t continue to borrow
more and more.

The time comes when, personally or nationally, you have to pay back. Likewise, consumer greed
assisted by bad lending is not tolerable or sustainable.

We, as citizens, contribute through the democratic process to influence the laws of the land, which
reflect the mores of our society.

In the case of economic activity, we as accountants should be actively influencing behaviours of

businesses by having a view and expressing it.

I have learned that I must have an insight into the financial state of my nation and demand good
government of our economy. I have learned that regulators must act in advance of problems and be
supported in those actions by public opinion.