| Paul Volcker | ||||||
Seasoned international bankers believe that changes are now necessary in the area of off-balance-sheet financing – an activity that has exploded out of all recognition in the past decade or two. “Deregulation started 20 years ago and has gone way too far,” says Minos Zombanakis, a well-known former Euromarket banker who is now an international financial consultant. “To allow off-balance-sheet financing of such enormous amounts is ridiculous. Banks use off-balance-sheet structures all the time to avoid capital adequacy.” He adds: “The whole idea of off balance sheet is wrong. Consolidation is a necessity. You can use any kinds of structures during the year that you want, for administrative purposes or whatever, but when it comes to reporting, you must consolidate. That is the only way to protect the investor.”
The much-criticised ratings agencies may be able to contribute in this regard. “Off-balance-sheet financing is a very legitimate area of concern,” says Christopher Mahoney, senior managing director at Moody’s. “There are highly creative people in the investment banking and accounting worlds who have found all sorts of ways to move risk off balance sheet, and there is enormous room for improvement in disclosure.”
According to Mahoney, the key in off-balance-sheet and SPE financings is the extent to which risk has really been taken off the balance sheet of the company and transferred to a genuinely independent, new at-risk owner. In the case of Enron’s SPEs, it clearly had not. That is why the partnerships rebounded on the company with such devastating effect.
Lascelles at the CSFI says one of the greatest difficulties in off-balance-sheet financing is in deciding what constitutes arm’s length. “Enron is a classic example of something that was supposed to be at arm’s length and wasn’t,” he says. “But it is a very judgmental issue.”
In the case of securitization – the area where special purpose vehicles are most commonly used and which, in most cases, constitutes prudent and legitimate financing strategies by banks and companies – regulators examine very closely the extent to which risk has been genuinely transferred and whether it can rebound.
So do the rating agencies. In many securitization structures – such as bonds backed by mortgages and credit-card receivables issued by banks, where the risk has often not been truly transferred – Moody’s and S&P consolidate the financing back onto the relevant bank’s balance sheet for capital ratio analysis purposes. “Our job is to make sense of what is presented to us and determine the extent to which risk has really been transferred off the balance sheet and away from the company,” says Mahoney.
In most cases, banks use SPV securitizations to free up regulatory capital and improve their capital adequacy ratios. But for credit rating purposes the deals are usually put back onto the balance sheet.
David Fanger, senior vice-president at Moody’s, says: “Most traditional securitization structures do not transfer risk. A greater focus on risk transfer rather than accounting advantages would be a good thing. But there are other benefits: it’s a cheaper form of financing, you can match assets and liabilities better, it reduces interest rate risk and it can be a better way of managing the business.”
One Wall Street banker says the investigations into the Enron scandal will inevitably mean changes in the world of financial engineering, in which investment banks have generated huge revenues by designing innovative products to take advantage of tax and accounting loopholes.
“Even where off-balance sheet financing is legitimate, the level of disclosure ought to be a lot higher,” he says. “If people are not prepared to let their investors know what they are doing, then perhaps they shouldn’t be doing it.”
He adds: “Investors need a proper roadmap – what the instruments are, how much they contributed to earnings, what the accounting treatment is and so on. It is not acceptable any more for companies to practice exotic financial engineering and accounting tricks with extremely scanty disclosure.”
Testifying to the Senate committee, former Federal Reserve chairman Paul Volcker – whose experience of public finance and financial markets is second to none – expressed the central dilemma of an accounting profession left trailing in the wake of high-speed financial innovation. “The fact is that the accounting profession has been hard-pressed to keep up with the growing complexity of business and finance, with its mind-bending complications of abstruse derivatives, seemingly endless varieties of securitizations and multiplying off-balance sheet entities,” he said. “The new profession of financial engineering is exercising enormous ingenuity in finding ways around established accounting conventions or tax regulations. In the rapidly globalizing world of finance, different accounting standards and methods of enforcement in different jurisdictions present increasing hazards.”
Investment bankers may need to change their focus as regulators and accountants catch up with them. But no-one doubts that they will find ways to keep innovation alive and their fee-earning power high. A Wall Street lawyer adds: “Investment banks will carry on regardless until someone puts a gun to their heads and says: ‘Stop. Now.’ It is most unlikely they will stop doing anything until they are told to do so. And even if you do put down a dam, like water they will always find a way around it.”
