Chapter 3

Regulatory bodies such as governments and multilateral institutions

establish financial regulations and legal procedures, while independent
self-regulatory associations attempt to coordinate standard practices
and facilitate industry supervision.
Professional associations, policy think tanks, and research institutes
undertake an observational role by collecting and analysing data,
publishing reports and policy recommendations, and facilitating public
discourse on global financial affairs.

The global credit crunch and toxic assets

During the 'Credit Crunch' of 2008, the phrase 'toxic assets' was used
by the international media to describe the range of financial products
traded by banks and other financial institutions in order to earn income
and lay off risk.
To understand the problem of toxic assets it is first necessary to
understand how banks have traditionally moved to lay off risk through a
process of securitisation using 'Collateralised Debt Obligations' (CDOs).
Securitisation through CDOs

When banks lend money to borrowers (for mortgages, car loans etc.),
they invariably try to lay off their risk by a process of securitisation. This
involves selling the asset from the bank’s statement of financial position
to a company called a 'Special Purpose Vehicle' (SPV). This sale
generates cash for the bank in the short term which can then be lent
again, in an expanding cycle of credit formation.
CDOs are 'packages' of many securitised loans, which are put together
by an SPV and sold to investors. The investors decide what level of risk
they are prepared to tolerate and invest in an appropriate grade of CDO
accordingly. The CDOs are then traded between investors (usually
banks).
The Credit Crunch

During the late 2000s, it became apparent that the banks had pursued
borrowers so aggressively that many of the loans sold to SPVs in the
securitisation process were likely not to be repaid (so called 'sub-prime'
loans). This in turn meant that it had become very difficult to trace
which CDOs represented loans which were sound, and which were
likely to be defaulted. Even some CDOs which were sold as AAA grade
investments were found to be unexpectedly risky.

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Consequently, suspicion grew in the financial markets that some banks'

statements of financial position were carrying large amounts of CDOs
which were not worth what they appeared to be.
This meant that inter-bank lending reduced dramatically, as banks
viewed each other with suspicion.
These CDOs are known as toxic assets.
The main problem is the uncertainty about which loans (and CDOs) are
sound and which aren’t. In practice, until time passes and some of the
loans are repaid, it will be impossible to tell which banks’ statements of
financial position are most badly affected.
The impact on business in general

As a consequence of the credit crunch, the banks have been more

reluctant to lend and have set more stringent lending criteria. This has
meant that many businesses have struggled to refinance their debts.
Various financial stimulus packages introduced by governments in
2009 – 2011 helped to encourage banks to lend, and therefore enabled
businesses to source finance to fund growth.
Numerical example of securitisation (and tranching)

Smithson Bank has made a number of loans to customers with a

current value of $500 million. The loans have an average term to
maturity of four years. The loans generate a steady income to the bank
of 9% per year. The company will use 95% of the loan pool as collateral
for a collateralised loan obligation structured as follows:
 70% of the collateral value to support a tranche of A-rated fixed
rate loan notes offering investors 7% per year.
 20% of the collateral value to support a tranche of B-rated fixed
rate loan notes offering investors 10% per year.
 10% of the collateral value to support a tranche of subordinated
certificates (unrated).

Required:
Calculate the maximum rate of interest that Smithson Bank can
afford to pay to investors in the subordinated certificates.

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Solution
In order to estimate the returns an annual cash account should be
created showing the cash flow receivable from the pool of assets and
the cash payments against the various liabilities created by the
securitisation process.
Receipts $m Payments $m
$500m × 9% 45 To A class $332.5m (W1) × 7% (23.275)
To B class $95m (W2) × 10% (9.500)
––– ––––––
45 (32.775)
––– ––––––
Excess (45 – 32.775) could be 12.225
paid to investors in the
subordinated certificates
The payment of $12.225m to the subordinated loan holders would
represent an effective return of
$12.225m/($500m × 95% × 10%) = 25.7%
This is therefore the maximum rate that the bank can afford to pay.
(W1) A class total $500m × 95% × 70% = $332.5m
(W2) B class $500m × 95% × 20% = $95m
Student Accountant article

The article 'Securitisation and tranching' in the Technical Articles

section of the ACCA website provides further details on this topic.
The Eurozone debt crisis

The global financial crisis which started in 2007–2008 caused problems

with the liquidity of banks and, as a result, lending and economic
growth faltered. However, many of the loans made to both
governments and private organisations had assumed certain levels of
growth and when these failed to materialise, problems arose with
repaying and servicing the debts.
In particular, several countries within the Eurozone (notably Ireland,
Portugal and Greece) had to be bailed out by the other members of the
European Union.
As the crisis developed, the loss of confidence in the countries affected
led to rises in the bond yields required on their government debt.
Given the amount of debt their governments had, bond yields quickly
achieved levels at which the governments could no longer afford to
service their debt.
This loss of confidence was fuelled by downgrades from the credit
rating agencies, media speculation and speculators betting against the
Euro and/or certain countries.

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Free movement of capital and money laundering

The removal of barriers to the free movement of capital

The free movement of goods, services and capital across national

barriers has long been considered a key factor in establishing stable
and independent world economies.
However, removing barriers to the free movement of capital also
increases the opportunities for international money laundering and
terrorist financing.
Money laundering is a process in which assets obtained or generated
by criminal activity are moved or concealed to obscure their link with
the crime.
The international fight against money laundering and terrorist
financing

Ever since the second world war, organisations such as the

international monetary fund (IMF) have been working to establish a
multilateral framework for trade and finance.
However, terrorist activities are sometimes funded from the proceeds of
illegal activities, and perpetrators must find ways to launder the funds in
order to use them without drawing the attention of authorities.
The international community has made the fight against money
laundering and terrorist financing a priority. Among the goals of this
effort are:
 protecting the integrity of the international financial system
 cutting off the resources available to terrorists
 making it harder for criminals to profit from their crimes.
The IMF is especially concerned about the possible consequences of
money laundering on its members’ economies, which could include
risks to the soundness and stability of financial institutions and financial
systems and increased volatility of international capital flows.
Outcomes of the fight against money laundering and terrorist
financing

One of the results of this activity is to create a wide definition of the

offence of money laundering to include:
 possessing, dealing with, or concealing the proceeds of a crime
 attempting or conspiring to commit such an offence
 failing to inform the national financial intelligence unit (FIU) of
knowledge or suspicion of such an offence.

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Furthermore, the international efforts to combat money laundering and

terrorist financing have resulted in:
 the establishment of an international task force on money
laundering (the international Financial Action Task Force on
money laundering (FATF))
 the issue of specific recommendations to be adopted by nation
states
 the enactment of legislation by many countries on matters
covering:
– the criminal justice system and law enforcement
– the financial system and its regulation
– international co-operation.
The implications for the financial manager

The regulatory framework recommended by the FATF and

implemented in countries throughout the world, places significant
responsibilities on accountants and other professional advisors.
The rules are designed to ensure:
 all customers are properly identified as legitimate and no
anonymous accounts are permitted
 any suspect financial activities are immediately reported to the
appropriate authorities
 records of all due diligence investigations and financial
transactions are kept for the proscribed number of years
 adequate and appropriate policies and procedures are
established to forestall and prevent operations related to money
laundering or terrorist financing including staff training
 sanctions for non-compliance are in place.
The laws implemented by most countries have had a significant impact
on professional accountants who are obliged to:
 undertake customer due diligence (CDD) procedures before
acting for a client
 keep records of transactions undertaken and of the verification
procedures carried out on clients
 report suspicions to the relevant financial intelligence unit (FIU)
e.g. the Serious Organised Crime Agency (SOCA) in the UK.
Professional accountants are not in breach of their professional duty of
confidence if, in good faith, they report any knowledge or suspicions of
money laundering to the appropriate authorities.

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Penalties for non-compliance can be imposed by the regulator (such as

the financial services authority in the UK) on any firm or individual. In
addition, the ACCA may take its own disciplinary action against its
members. It is therefore essential for all accountants to:
 monitor developments in legislation
 stay abreast of the requirements
 implement all recommended protocols.

Strategic issues for MNCs

National governance requirements

Different countries have different governance requirements. These

national governance requirements will impact on the behaviour of
multinational organisations.
Individual countries have imposed their own restrictions from time to
time by, for example, reserving certain shareholdings for their own
nationals or by limiting the transference of profits or royalties. But even
governments have to tread carefully lest the subject of their attentions
abandons the market altogether.
The mobility of capital

One of the drivers of globalisation has been the increased level of

mobility of capital across borders.

Implications of an increased mobility of capital:

 Lower costs of capital.
 Ability of MNCs to switch activities between countries.
 Ability of MNCs to circumnavigate national restrictions.
 Potentially increased exposure to foreign currency risk.
'Local risk'

Local risk for multinationals includes the following:

 Economic risk is the possibility of loss arising to a firm from
changes in the economy of a country.
 Political risk is the possibility of loss arising to a firm from actions
taken by the government or people of a country.
Examples of political risk:

Confiscation political risk

This is the risk of loss of control over the foreign entity through
intervention of the local government or other force.

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