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Thursday, 21 January 2010

I lost my glove tonight...

Well, it was borne out of anger, causing stupid behaviour and the next minute my glove was gone, fallen between the platform edge and the almost departing train. Next followed frustration, with a few expletives thrown in for good measure.

However, I look to this episode and try to draw a lesson from it. An economic lesson and this is what I came up with:

Gloves come as pairs. To the two handed individual, one glove is not really fit for purpose, except if you decide to permanently put the other non-gloved hand in your pocket, thereby proverbially 'tying one hand behind your back'.

This is what happened, figuratively speaking, during the lead up to the financial crisis.

Accounting regulatory standards meant that Financial Asset valuations had lost one of its gloves. The intentions were good, but as financial instruments increasingly became impaired the 'Mark to Market' ruling of IAS39 meant it forced banks to write-down instruments to market values.

Effectively the Profit & Loss account (Income Statement) became the dumping ground for the now 'toxic' assets. In the past any revaluation was done via the balance sheet.

The intentions of IAS39 were good, with a stated aim of increasing transparency and better valuations of banks and financial institutions, however, this was drafted and conceived during the go-go boom years, not anticipating a catastrophic downturn such as the one we just experienced.

Another factor I am paying a bit more attention to these days is the pricing of risk into financial products. As previously commented, if risk is priced in properly and this resulting premium capitalised as a reserve, then we should have a buffer for the rainy day.

The one problem or challenge we face is competition. Competition generally should encourage innovation, efficiency and cost reductions, via scale, however, it also encourages risk taking at the expense of risk pricing. This is one of the areas whereby our 'free-market mechanism' fails the test and does not 'balance the books' effectively.

How and what we do to address this deficiency is the stuff future blogs will explore in more detail.

But for now, the one-gloved 'soul' has had to wave goodbye to a matching pair.

theMarketSoul (c) 2010

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