From irregular credit to entity failure

Credit & Financial Management Review, Third Quarter 2002 by Wasserman, Samuel

Abstract

In today's uproar about poor corporate governance, insufficient discussion has taken place regarding the prevalence of poorly structured corporations and how they got that way. Critical analysis of the reasons for such widespread acceptance is urgently needed. Rather than continue to place exclusive blame upon corporate leaders and their unique personalities, it is time to find out why such personalities might be required to supervise entities that are irregular in form and purpose. Poorly designed large corporate structures are not new. However, it is the degree of such acceptance--less during the 1980's and then with no reservations during the 1990 's-that leads to a worsening of the size and risks of badly structured companies.1

Corporate governance, accounting, and necessary causes

Poor corporate structure is an important, unexplored similarity between today's crisis and the breakdown of the employment resource base during previous, prolonged economic recessions. This was particularly the case in late 1930 and 1931.(2) This article completely redirects the focus of analysis of this subject away from corporate governance as a reason for entity failure, and directs our attention to credit expansion and the role of non-viable corporate structures in cycles. The tendency of entity failure does play a role in whether a cyclical decline is brief or sustained. This again is the reverse of popular logic that typically says the inverse; that recessions cause firms to fail. This article vigorously rejects that line of thought as a fatal error of causative logic.

The argument is simple. It says that artificial credit expansion inevitably induces poorly structured firms to absorb (monetize) such credit, and that such firms eventually merge as the credit expansion continues (it usually does) and the outcome is entity failure and a decline in the employment base. Cycles result from this sequence. Today's crisis takes place as we anxiously walk on the precipice of the future of the employment resource base.

This re-direction of emphasis points back to the uproar about stock analysts after the NASDAQ meltdown in 2000. At that time, nobody was looking at accounting as an even greater culprit in the crisis. It was natural that many people, especially politicians, looked for human personality and behavior as the ultimate cause instead of looking at the systems and procedures built up over many decades, and even hundreds of years, as the primary causes. It was not until Enron , many months later, that accounting's structural flaws became the subject of popular curiosity. Since Enron, accounting inefficiencies have exploded into a major crisis of historical dimensions, adding another human element to the pundits' criticism that corporate leaders and their support systems, including accountants, are fully to blame for today's problems. This logic puts human behavior in corporations at the front of the chain of causation. This logic does not stand up well to scrutiny.

The erroneous reasoning that points to the crisis of corporate governance as a necessary causative factor for entity failure distracts us from necessary causation and correct logic. The necessary cause regarding corporate structural collapse is found in the purpose of such entities. Poorly structured corporations are designed not to withstand cyclical events, but are designed exclusively and very efficiently to absorb irregular, artificially inflated monetary credit. Irregular credit-the primary necessary cause-occurs as a combination of 1) poorly executed evaluations of credit grantor/customer risk in bank loan and securities capital markets, and 2) excess bank credit resulting from monetary interventions by central banks to increase the money supplies.

In this definition of entity failure, we may view poorly structured corporations as a partner in a wider system willing to move risk to entities unable to sustain such risk.

Good things happen when trade in contingent, risky, claims transfers risk towards those more willing and able to bear it and away from those less willing and able. At times, however, risk is traded to parties most willing, but quite unable to bear it. This misallocation may reflect ignorance or dishonesty and fraud. When disorderly, illiquid markets prevail, the financial market system not only fails to allocate the unavoidable global risk efficiently, it creates additional, avoidable risk, through costly defaults and bankruptcies and unnecessary economic dislocation. (Buiter, Recession and Financial Crisis, April 2001)4

Today, we witness many instances of misallocation, and this is critically relevant to the discussion of credit, credit granting, and liquidity. The discussion must focus, therefore, on the process of misallocation as an irregularity of credit. The popular focus upon human personality traits of corporate leaders must give way to a meaningful discussion about the breakdown in credit granting, how and why it has occurred today, and how this may support an eventual, sustained contraction in credit. Without this discussion, it will be nearly impossible to see that today's financial crisis is typical and ordinary-regardless of its specific damages.