‘We need innovative financial products that are devoid of gambling elements’

Saikat Neogi 
Posted: Saturday, Sep 26, 2009 at 2126 hrs IST

The global financial crisis has underlined the need for responsible corporate governance. Many of the nuances are explained in R Venkata Subramani’s latest book Accounting For Investments: Equities, Futures and Options published by John Wiley and Sons. A chartered accountant by profession, Subramani is the chief operations officer of Chennai-based Variman Capital Markets Services and is responsible for valuation and accounting, partnership allocation and accounting for companies. He has also taught at the Institute of Chartered Accountants of India and the University of Madras. Subramani in an interview to FE’s Saikat Neogi explains the changes in the accounting process after the global slowdown, credit default swaps and peer review of accounts. Excerpts:

How has the financial crisis underscored the need for greater responsible corporate governance within financial institutions?

It is now a known fact that some large financial institutions did push under the carpet certain losses in some innovative products either to dress up the periodical results or to protect employee bonuses. When the already inflated and heated up markets developed cracks, these unhealthy practices came to the limelight as these could no longer be covered up. The losses snowballed with domino effect, resulting in all round lack of trust amongst the financial institutions per se, which aggravated the situation calling for bailout measures from the government. Though this originated in the US, some of these events replicated in other parts of the world. Perhaps, a lot of these could have been minimised if there were a greater responsible corporate governance within financial institutions.

What are the accounting lessons that one can learn from the global economic crisis?

Accounting is based on common sense. If something defies common sense, it obviously cannot stand the test of time. Accounting standards are designed to provide uniformity in accounting and reporting and to ensure adequate disclosures are made about all aspects of material transactions. The lesson that one needs to learn from this crisis is that the regulatory compliance and reporting and disclosure requirements set forth in accounting standards should be followed in spirit for their own welfare in the long run or else it will boomerang on the entire financial community sooner than later. If there is a trouble, it’s better to bring it to limelight soon and never resort to cover up by applying ‘accounting skills’.

What kind of innovations are called for in the global financial institutions in the near future?

The Street is known for its creative and innovative financial instruments to cater to the risk appetite of every type of investor. Some financial instruments like the credit default swap (CDS), which have become extremely popular since 2000, have been suffering from certain serious flaws. Some economists and financial experts have been harping about the dangers of these products and unfortunately the whole world has been forced to learn a lesson in a very hard way. These inputs will undoubtedly force the global financial institutions to think and come up with innovative products that are devoid of gambling elements.

How can the government reform the financial sector? What kind of checks and balances are needed?

OTC products should be regulated. The financial sector has created several innovative products to take care of the requirements of different types of investors on the one hand and the issuers on the other. In all these, the government has to ensure that unchecked and over ambitious greed on the part of investors does not affect other investors. In other words, while investors with risk appetite should be fed with products that suit their requirements, the loss if any suffered by those investors should be protected by being adequately funded—not causing any domino effect on other investors. The exchange traded products usually ensure this. The government should ensure the same level of safety through appropriate means to both the counter parties of even OTC products. This will go a long way in ensuring financial stability and effectively acting as a shock absorber against any financial crisis.

Will the credit derivatives market regain investors’ confidence?

Not immediately in the present form. Credit derivatives in the present form may not regain investors’ confidence. There is a proposal to ban credit default swap in its present form. India has been very wise in staying away from this devastating product by the good efforts of RBI. In fact, CDS has been one of the main reasons for the present global financial crisis. CDS in the present form suffers from some serious flaws. There is no requirement of insurable interest for this product, turning it into a convenient form of gambling. Look at the numbers — the notional amount of CDS outstanding at the end of 2007 was around $62 trillion as compared to around $25 trillion of the total fixed income securities issued in the US, indicating the gambling element. Unless these flaws are eliminated, credit derivatives are unlikely to regain investors’ confidence.