Vol 5 (2008) - Issue 6

Article preview

Behaviour, Distress and Regulation

Behaviour and perception affect the market. In fact, there is often such a significant effect caused by market behaviour that the difference between market behaviour and market abuse is difficult to spot. This has been a constant theme for regulators the world over. This brief editorial seeks to consider some of the effects of behaviour on stress and distress in a business.

Cyclicality and credit as a scarce resource

One of the most difficult things to track down in the market is the abuse of it for improper gain. The Financial Services Authority (FSA) in the UK has been criticised on several occasions for not taking sterner or more effective action to prevent market abuse through meting out retribution on those who have been abusive. In a world where information travels in quantity at speed, it is difficult to keep track of everything and more difficult to disentangle messages to unearth whether or not they have originated from a proper or improper source and, if improper, where that source resides.

The business of ‘shorting’ has been a hot topic recently, especially in the UK, where the FSA has made moves to ‘out’ short sellers of shares, requiring disclosure of short positions in companies that are the subject of a rights issue. The heightened sense of urgency arises from the perceived systemic risk posed by the shorting of financial stocks and shares – the businesses with a close connection to the public.

As we saw with Northern Rock, the fact that everyone has a bank account (which is a loan to the bank) means that news generated about a retail bank can have a significant impact on its liquidity position if other borrowing sources are not available. Reporting of significant share price movements in the press have an effect on the behaviour of the individual who, in turn, can then have an effect on the financial destiny of a business.

To ‘out’ those who short sell shares in rights issue stocks and blame rumour-mongers and the press for the problems and then to look no further is to misunderstand the reasons for failure and the financial markets’ woes currently. The provision of credit to individuals and institutions has become a relatively scarce resource having been an abundant one in the recent past – credit provision, like many other parts of the financial market, is cyclical – this should come as no surprise.

The consequences of battling for a scarce resource are that there will be institutions and individuals who do not receive new credit or have existing credit lines ‘pulled’. Whether that is the public withdrawing their life savings or Lehman Brothers not being in a position to renew a revolving line of credit the result is the same – find an alternative source of funding, learn to live with less cash or perhaps even go bust.

Behaviour as a causal link in market pricing and distress

During the early 2000s, analysts criticised businesses for having ‘fat’ balance sheets, not working their assets, for conservative funding models, low leverage and retaining too much cash. Businesses with these characteristics were heavily discounted by the market – not for their prospects, but for their perceived inefficiencies.

Searching for value, a chief executive and his executive management team would often strive to ‘improve’ efficiencies – borrow to repurchase shares, sell and lease back assets, use cash to acquire or hand back to shareholders, reduce the cost of funding by refinancing in the short-term markets and so on. Behaviour driven, at least to an extent, by the market. The market would reward successful efforts and continuing earnings with a higher share price relative to peers. The executive would be aligned with that success, being compensated in part with awards of those shares.

All the time, the assumptions made which drove the business plan adapted to the changing market characteristics during an impressively consistent credit expansion phase. A principal assumption of many was that ‘the financing would always be there’. Credit markets became consistently liquid and funding was consistently available. Financiers pushed the envelope of lending in seeking to satisfy the demand of their clients for ‘paper’, fuelled by the thought of another ‘record year’ and what that would mean for them. Echoes of ‘while the music is playing, you have to keep dancing …’ filter round.