Fraud as the final step in a credit boom

 

There has been great many discussions about introducing new legislature concerning the overhaul of the financial industry. There has been calls for Glass-Stegall to be re-introduced. The Dodd-Frank overhaul act of 2010 is a massive 800 page juggernaut aimed against the “egregious” acts committed by Wall Street during the latest  recession. But, do laws really help against fraudulent behavior or are there deeper roots regarding this problem?

During the boom faze of the credit cycle, prices of factors of production and capital goods rise in value, the stock market rises and there is a sense of general euphoria. Companies are willing to go into debt to finance and expand entrepreneurial projects. They are romanced by the banking sector and the cheap funds that are all of a sudden granted to businessmen almost at no cost. Profits soar, and the balance sheets of companies have never looked stronger.

Assets are inflated in value, along with revenues. Projections based on current sales and expenses are prolonged into the future with expected double digit YOY growth. Companies in this period don’t really run high capital buffers to protect them in case of a sudden fall in ongoing revenue. They rarely engage in any accounting for reserve losses on their accounts receivables and a hectic schedule of ever increasing demand reduces their inventory amounts. The demand can be so excessive, that companies frequently neglect the qualitative value of there assets, as the only goal is to satisfy the voracious appetite of the consumers at large.

However, the fairytale economy built on money creation is an illusion, and soon companies will find themselves in trouble. The first thing that comes about is a cry for more liquidity; that is, the business community starts holding a grudge against the government due a “note shortage”, a situation where there isn’t enough funds in the economy for completing there projects of longer durations. Businesses are frightened due to rising interest rates and higher costs of going into debt or rolling over their current debts. Funding becomes an issue.

The only way for businesses to appear in good health is to engage in deceptive accounting or sometimes go so far and engage in embezzlement and fraud. Companies, which are first effected try to get rid of poor performing assets. But, instead of selling them, they usually engage in complicated repo transactions, where they try to ”window dress” their current financial mess.

(This closely resembles the situation and fraud perpetrated by Olympus in Japan. They tried to hide losses for over a decade in an ingenious scheme that finally unraveled a couple months back. For an accounting description of what happened read this post by an independent CPA from San Francisco located on retheauditors.com.)

But the window dressing and repo shams can last only for so long. The company will eventually run into problems paying back their vendors. They again decide to engage in aggressive accounting techniques using vendor financing. The troubled firm will sell their account payables for note payables. The cash injection will be recorded on the cash flow from operations (under IFRS) and when the note comes due, they may resort to booking it on the financing portion of the cash flow to make it appear that the firm is on steady grounds when its core business is concerned.

Fraud, in this context was generated not by an evil ambition of the businessman, but by a desperate attempt to stay afloat. That is usually what happens in a boom period. I am not vindicating this behavior, just stating the catalyst that brought such dubious behavior.

In a “normal” economy, these things happen as well, but are more profound during the end of the boom faze. Some other ways to manipulate earnings or financial statements is to: book revenue without shipping the product (bill and hold), booking a revenue when accrual accounting doesn’t allow it, lowering contra accounts to artificially prop up assets, capitalizing an expense when conditions are not made for it to be capitalized, engaging in aggressive securitizations, manipulating the life cycle of an asset, booking future profits, lowering the carry of defined pension benefit plans, using an asset as an operating lease instead of properly booking it as a finance lease etc.

The politics of employment

 

It is really sad that in todays world, one would get a job not because of his/her merit, but because of politics. This next article from business.hr really makes me sick:

“Minister of Environmental Protection and Nature Mirela Holy, in a written request addressed to the President of Railways Holding Renu Valcic tried to save one secretary from being fired reports HRT Broadcasting.

The written request in the first sentence emphasizes that the  the secretary is the wife of  a party colleague, but the CEO of Railways Holding Valcic rejected this request. Holy says that it is not a political intervention, but it is a recommendation for a humane attitude toward an employee of the Railways, the reports of HRT.  I appealed. I sent an official request from the mail, but mail from the party to a party colleague, "said the show 'Open'.”

Not a political endorsement? Humane attitude? This is one of many real life situations in which individuals wishing to resume a status quo situation are left begging to the government to save their rightfully earned workplace.

Insomuch, I wouldn’t be surprised if this individual earned twice as much as she would have earned in an unsubsidized industry subject to the laws of supply and demand for wages.

Fractional reserve banking and its effect on maturity mismatching

 

The following is an excerpt from my presentation at the 3rd International Student’s Conference: Time to Rethink Economics, Beyond Frontiers that took place in Zagreb, Croatia in June, 2011. The title of the working paper is: Dangers of maturity and currency mismatching in a fractional reserve banking system with the example of Iceland and a look at alternative banking models.

Fractional reserve banking and its effect on maturity mismatching

For one to understand modern banking, history is an essential backbone unto which the pillars of modern financial intermediation are to be analyzed. The first and foremost example is Ancient Rome and the introduction of Roman Classical Law. In the time of great advances in philosophy, the beginnings of primal government structures and other forms of key institutions, a form of so-called jurisprudence evolved. Jurisprudence came about from the nature of societal and human understandings championed by Roman scholars, as” […] they embarked on an interpretation of legal customs, exegesis, logical analysis, the tightening of loopholes and the correction of flaws; all of which they carried out with the necessary standards of prudence and equanimity.“ (de Soto, p. 24)

The work of the jurisprudence was subsequently archived thanks to Emperor Justinian during the middle of the six century, as to be later on compiled into one monumental book, the Corpus Juris Civilis. Roman legal scholars, as part of this jurisprudence came to a conclusion that haunts modern banking to this very day. The pivotal conclusion regarding not only banking, but the core social edifice of society, but in the realm of banking, was the distinctive and fundamental difference of demand deposits which represent a sum of money deposited at a depositary institution, receiving the name of a monetary irregular deposit (to be shortly explained) also known as a tantundem, and a loan contract, under which an individual relinquishes his/her monetary sum for a distinctive period of time, at interest, also known as a mutuum contract.

A monetary irregular deposit stems from the notion of fungible goods deposited at a depository. This means, that if someone wishes to place a certain good at a bank for safekeeping, for example, oil, grain and so forth, it is in the depositories obligation to immediately relinquish this good at the demand for the depositor. Since grain and oil are by nature fungible, it is economically inappropriate to keep these goods separated or compartmentalized for the marginal cost would be too great. Therefore, grain and oil are kept together, since no qualitative or quantitative standards are violated.

Moreover, this fungible asset is, in its essence, a demand deposit. Any failure of delivery results in a law suit against the depository not being able to bring about this demand to its rightful owner. “In other words, the owner of the grain warehouse or oil tank can use the specific oil or grain he receives, either for his own use or to return to another depositor, as long as he maintains available to the original depositor oil or grain of the same quantity and quality as those deposited“. (de Soto, p. 59)

A demand deposit is not relinquished for any time. It does not represent a transfer of present consumption for future consumption, unlike a loan (mutuum). A loan transfers present for future consumption, in line with consumer preferences. One of the key roles here is the charging to interest.

Why banks grant interest payments to depositors? There is clearly no transfer of consumption patterns when a deposit is kept for safekeeping. A monetary loan on the other hand signifies a transfer of ownership where a demand deposit does not. In that case, banks are obligated to maintain a 100% reserve requirement for demand deposits.

However, fractional reserve banking manipulates this legal and economic understanding of not only ownership transference, but time transference of funds. Notable examples of this misconception derive all the way from ancient times to modern day banking with the clear deviation from logic, adopted in Anglo-Saxon Law. The practice of loaning out demand deposits and concealing them as loans is a concept known in the Middle Ages as depositum confessatum.

Under this veil, banks had the ability to pay out interest to depositors, even though it should be reversed, the depositors for various reasons, decide to safe keep their funds, and must pay a service fee, not the other way around!

Economic activity is therefore altered, for confusion enters the market, and one doesn’t know if funds are genuine savings, as in loaned out, or funds are safe-kept, to be instantly used. Primary examples include the government sponsorship of these actions in the past, so-called ius privilegium. Under such circumstances, banks were allowed to create credit out of nothing, loaning out deposits that should have been backed by a 100% cash reserve.

Fractional loaning of demand deposits, therefore, when visualizing from an accounting perspective, transfers leverage and unjustified profits from society to banks practicing this form of intermediation, creating a profound and unjustified act of usury.