Without risk-taking there is no banking industry

Bob Diamond, the chief executive of Barclays Capital, said recently in a radio interview that without risk-taking there is no banking industry (link to radio interview).

This is correct, though may be a concern for those who believe the traders who take the risk are to blame for the banking crisis. Of course, traders should be rewarded for successfully making money from the active use of risk though the real question is whether the risks are properly understood and therefore whether the returns are sufficient and rewards appropriate.

Actually, what this highlights is the need to properly measure, manage and report the risk being utilised in a relevant way, perhaps pointing the finger at the accounting and audit practices; do they expose the risk sufficiently to help its management or just to meet fiduciary and regulatory requirements?

Another outstanding question, emanating from the same underlying issue, is why did the Lehman Bros' published and audited accounts not give a proper warning of their impending and sudden failure; surely it wasn’t due to new trades after the accounts were published but a consequence of risk in the books not being recognised.

A further side effect of the existing accounting policies is that they potentially put incentives in the wrong place, particularly those for companies that actively manage the market risk of their own assets. For example, trading decisions driven primarily by hedge accounting policies, rather than for risk management, could result in the diversion of P&L from assets to trading groups while leaving some unmanaged risk with the asset. Interestingly, recent results published by a leading utility with an active trading group show huge trading P&L and weak asset results; leaving the investment analysts questioning the organisational set up.

The common factor is that accountants and auditors are really only reporting a snapshot of the financial state rather than the real risk in the business that can impact future performance; this could be an underlying reason for the recent problems. These accounting driven decisions are also the reason many organisations are structured in such a way that helps to satisfy accounting standards rather than to best manage the asset's profitability and risk. This is not a matter of MTM or accrual accounting but how to represent the state of the business risk.

In the rush to blame the traders and their bonuses, the regulators and the industry commentators appear to have completely missed that the current accounting rules are a significant contributor to the crisis we have seen in the markets!