Predictably Irrationality and Corporate Governance

In the video presentation, Dan Ariely, author of "Predictably Irrational", attempted to provide some insight to what is now called behavioural economics. Using findings in social experiments he conducted (these findings are better detailed and explained in his book), he explained, in very rational way, why human behaviours are sometimes irrational- and predictably so.

He went on to apply the findings in explaining the possible reasons why Enron, and by extention other corporate failures, collapsed.

Perhaps some lessons here for instituting good corporate governance?

The Paradox of Re-defining Marked-to-Market accounting

In February 2009, U.S. Treasury Secretary Timothy Geithner announced the setting up of a Public-Private Investment Fund (PPIF) (in which both government and private entities contribute capital) to provide financing in buying up toxic assets from the banks. With these assets off the their' balance sheet, it was envisaged, banks can then proceed with the path of rebuilding its profitability and regaining the public confidence.

Also, with a well-capitalised entity holding these distress assets (mostly securitised papers back by mortgages or other loans), it can unwind these securities in a orderly fashion thereby averting a volatile downward vicious cycle in the values of these assets.

It was reported today that he will soon provide more details on the plan.

It was also reported in the past week that Federal Reserve Chairman Ben Bernanke had suggested that the 'Marked-to-Market' accounting policy should be revised, but not repealed, as "current rules did not lead to accurate valuations in times like these."

Subsequently, FASB (Financial Accounting Standards Board) announced that it will soon publish new guidelines to the application of 'Marked-to-Market' accounting.

I wonder if the soon-to-be-refined accounting standard will interfer with the Treasury's effort in cleaning up banks' balance sheet.

Let's assume that, following the implementation of the new accounting guidelines, banks need not write-down the toxic assets to their market values, what then is the bank managements' incentive to unload these assets to PPIF? Assuming that PPIF will only pay market prices for them, the banks will incur losses if they were to offload them to PPIF.

Indeed, even if banks are able to sell at or above the assets' carrying values, it will serve their interest to adopt a wait-and-see approach rather than rushing out and unload the distress assets. By doing so, they are hoping that PPIF's effort in buying up the toxic assets (from other banks) will be successful in stanbalising the credit market. With the return of order, they have a good chance in then unloading their own assets at even higher prices. In any case, even if PPIF fails to clear the clog and market prices remain depressed, no downside risk is perceived now that 'Marked-to-Market' need not strictly be adopted.

As a result, banks may continue to hold onto the toxic assets until they deem it to serve their serlf-interest to sell them- at a profit (!!!) and not necessarily to PPIF. What then is the point in setting up PPIF in the first place?

Hence, paradoxically, the redefining of Marked-to-Market accounting, which is supposed to help stabilise the financial market, may post a barrier in the receovery path to a sound financial system.

Updates on 30 March:

Bloomberg reports on the pending revision by FASB.

Profit Flaunting

Following Citigroup's statement in an internal memorandum (it was obtained by the media) that it was profitable in January and February 2009, the U.S. market rallied. And a day later, JPMorgan Chase's CEO also made a similar statement.

It is not normal practice that U.S. listed companies provide updates on profitability on a monthly basis. One wonders if the unusual acts were meant to provide confidence to the nervous investors holding on to their shares.

More importantly, now that two of the big banks had flaunted their interim profitability, who is next? Or more pointedly, for companies that see their share prices under pressure, who can afford NOT to provide the market with updates that they too are profitable, lest investors think otherwise?

Updates:

17 March: Standard Chartered Had 'Strong ' First Two Months

16 March: Barclays Says ‘Strong Start’ to 2009

12 March: Bank Of America Joins Parade, Says Sees Profit This Quarter