• Keith Dalrymple

To Swiss or not to swiss - that is the question

Opacity, regulatory hurdles, complexity and market concentration combine to provide excess returns and very outwardly-stable companies, industries or even countries. The opposite is generally viewed as true for transparency, clear accounting measures, limited but effective regulation and market competition. Firms, when given the choice, will naturally strive towards the first set of circumstances. The Swiss built a lucrative financial intermediation business on secrets that lasted decades.

Following the Great Depression, the United States opted for a transparent and competitive model of financial regulation that has largely delivered efficient allocation of resources, encouraging growth and innovation. Swiss banking profitability, in contrast, melted surprisingly quickly when transparency and clear rule of law were introduced to the system. Efficient markets bestow discipline and foster resilience, so what accounts for the US yielding to the inertia of recent trends to replace the Alpine nation as a place of fragile opacity over robust transparency?

The problem is especially pronounced in the financial sector (but hardly limited to it) where limited liability, patchwork legislation and non-transparent disclosures of risk have combined to create excessive leverage and systemic threats. The public bailouts of 2008/9 have exacerbated the incentives for agent profit maximizing behavior while locking the participants in a prisoner’s dilemma choices. If you let them, they will gamble.

At the same time, over the last two decades the number of companies listed on the US stock exchanges has halved while the rest of the world’s most liquid markets record an increase in registrations. Instead, the US faces a significant influx of offshore listers and hybrid-type complex securities with limited fiduciary duties, questionable governance practices and hard-to-gauge legal protection targeting retail and institutional investors onshore.

Not fulfilling its function of transforming duration and risk in a market-based competitive capital allocation, the US financial intermediation industry has consolidated further in search of oligopolistic profits. The hidden risks along with significant fees are pushed onto pension funds, insurance companies and other investors who are no better placed to absorb them than the banks were a decade ago. Caveat emptor can only be achieved if there is a meaningful measurement and disclosure of what is being sold.

Accounting quality and disclosures are critical for the system to self-regulate within the context of competitive market for capital. As long as additional assets can be “manufactured” without limits, valuations marked-to-wish and cashflows from uncertain future booked as profits today, the problems will persist. As more and more investors chase “superior” private and questionable returns, a self-reinforcing cycle will be at play.

As the Swiss experience shows, “Who doth not answer to the rudder, will answer to the rock”.

Victoria Dalrymple

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