Some research (Williams, 2001) and the general perception is that half of small businesses fail within a short period of time. In fact, in 1999-2000 the number of formal insolvencies economy wide was estimated at around 0.36% of all enterprises. (Bickerdyke, 2000) In 1991-1992 the figure was 1.04%, three times that ratio. Figures for July 2005 are 1.01% of companies entering insolvency as a percentage of companies incorporating. (Australian Securities and Investment Commission, 2005). Professor Michael Schaper from the ACT Small Business Review reported in the Australian Financial Review an exit rate of 8% where this rate is measure of how many businesses cease to exist. (AMP & NATSEM, 2005, P18) This is clearly well below the common belief. These figures may be contradictory and misleading but the fact remains small businesses cease to trade and this has ramifications for their owners, creditors and the economy. This paper will explore the typical reasons for small businesses ceasing to trade due to their inability to pay their debts with a detailed exploration of the process of insolvency and a look at the institutions and procedures they face. Some suggestions for avoiding such a fate will also be proposed.
The reasons for the short lived nature or insolvency of small businesses have been researched intensively over the last decades by academics and data is routinely collected by government agencies. These reasons for small businesses ceasing to trade are not mutually incompatible. According to some research the primary reason is inaccurate or non-existent books and records and the inability to use or understand financial statements and reports, (Williams, 2001 p149). . Undercapitalisation, including insufficient start-up capital and the lack of working capital is a significant factor. (Williams, 2001 p149). This can result from an inability to source finance. According to the 1995 Telstra Survey, 55% of funds come from owner’s capital and 43% from bank finance. (Jones, 2005) Successful borrowing from banks depends heavily on the owner/manager backing the application with a business plan and financial budgets including a cash flow budget. (Williams, 2001 p149) Cash flow difficulties can occur with overtrading with means the business is growing too fast. (Williams, 2001p149). Overtrading can be linked to poor inventory control which occurs when too much or the wrong type of stock has been purchased on the basis of inexperience or over enthusiasm. Poor inventory management can also mean too much cash is tied up in inventory for too long. Similarly, over capitalisation, which is the investment of too much cash in non-current or fixed assets, can impact negatively on the small business. (Williams, 2001 p149). Likewise poor control over costs and activity levels by not understanding the relationship between fixed and variable costs and their effect on profitability and the break-even point can have serious consequences for the small business. (Williams, 2001 p149). Poor control over credit can be another reason for the short lived nature of some small businesses. Slow paying debtors can misalign cash flow in that the business can be forced to be a slow payer to its creditors which can destroy its reputation with its suppliers who then may impose interest charges and restrict credit terms. (Williams, 2001 p149). Many owner managers take excessive private drawings from the business, particularly in the early stages, and can starve the business of cash flow. (Williams, 2001 p149) Fluctuating economic conditions with frequent price changes and interest rate volatility has also been cited for small business insolvency. (Williams, 2001 p149)
According to the report of the Inspector General on the operation of the Bankruptcy Act and used by the Australian Bureau of Statistics in compiling its snapshot of small business, (Australian Bureau of Statistics, 2001p78) the main reason for small business failure over the decade to 2001 was fluctuating economic circumstances, with 24% in 1983 down to 15% in 1998 and up to 34% in 2001. Excessive interest moved between 4.4% in 1983 to 9% in 2000 and back to 4.9% in 2001. Interestingly reasons with steady increases were gambling or speculation from 0.5% in 1983 to 3.8% in 2001 and personal reasons from 6% in 1983 to 17% in 2001. The lack of capital was steady at around 13% with the failure to keep proper books steady at around 1%-3%. Importantly the lack of business ability dropped from 33% to 9% over the period.
Market research is a vital part of ensuring business viability. Too often ignored by small business owner/managers who typically are convinced their product or service will work without first asking potential customers. They also fail to clearly define their target market. Price cutting is assumed to ensure successful competition. Short term thinking by underestimating how long it will take to enter a market and obtain a reasonable market share is also a pitfall to be avoided. Finally complacency in that small business becomes too reliant on promises of work when first starting. (Hingston 2001 P30)
A useful test for viability for small business is the financiers test. For example others should find it difficult to enter the market after you have entered and are successful. The business should have high margins and good profitability with good cash flows, funds for future development. Furthermore it should be able to survive if these margins are eroded. The business should appear able to survive for a number of years without requiring further investment or change. (Hingston 2001 P38) There are a number of common errors small business owners make when raising finance. Going ahead before raising sufficient funds to cover all the business needs. Predicting a higher or faster rate of sales than is likely. Not having an exit strategy. Overborrowing and then not being able to pay interest and principle repayments out of cashflow can create problems. (Hingston 2001, p66) Owners are putting assets at risk unnecessarily by not considering other security options when borrowing. Not having enough finance arranged when the business needs expansion and having to make larger owner’s drawings to meet expenses are also common financing mistakes. (Hingston 2001, P66) Being unprepared for a downturn in the economy by having borrowing arrangements in place if needed is a mistake. Not having enough cash flow to meet tax and other regular payments is common. Most of all overestimating the importance of raising finance in running a business. (Hingston 2001, P66)
Some of the institutions and procedures faced by small business when confronted by insolvency have improved over the last two decades.
The failure rate for small business in Australia in 1999-2000, at just 0.36%, was lower than a decade earlier. The decline could be the result of fewer company failures which may be explained by the changes to the Corporations Act that provided much greater scope for companies to trade their way out of financial difficulties. However the failure rate of unincorporated businesses remained relatively constant over the same decade. (Bickerdyke, 2000 P54)
A market economy based on competition will inevitably result in some businesses ceasing to trade. This should result in less efficient businesses being replaced by more efficient as measured by increased returns on capital. The OECD has noted how the entry and exit process can make a contribution to economic productivity growth. (OECD 1998 p112) However the law expects those involved to be able to recognize the warning signs early and act responsibly to avoid or lessen their creditors loses.
The small business owner may be unable to take corrective action when warning signs of approaching problems start. An examination of the financial position may indicate approaching insolvency whereby the business may be unable to pay its debts as and when they fall due. Steps may be taken to rectify the situation or to protect the directors and company officers from committing breaches of the Corporations Act. These may include an injection of capital, renegotiation of short term debt into long term debt if eventual payment is possible. This approach should only be contemplated if cash flow and profit projections support the decision. It may be possible to negotiate a rearrangement of the order of creditors. It only takes one unhappy creditor to force insolvency, so it may be wise to placate the unhappiest creditor first. (Hingston 2001, p176)
If the business can’t be saved there are a variety of possible administrative steps to be followed depending on whether the business is incorporated or a sole trader/partnership. Sole traders and human partnerships are covered by the Bankruptcy Act, 1996 (Cth) and administered by Insolvency and Trustees Services of Australia (ITSA, 2005). Incorporated enterprises are covered by Chapter 5 of the Corporations Act, 2001(Cth) and administered by the Australian Securities and Investment Commission. (ASIC, 2005)
Provisional liquidation where a creditor, shareholder or director can request the court to appoint a provisional liquidator to protect the assets of the company until an order for its winding up is made or some other action is taken.
Court approved schemes of arrangement between a company, its creditors and or its shareholders where creditors agree to stop pursuing their claims to allow the company to continue in business. The administrator may be required to cease trading, realise the assets and distribute the funds. A compromise where the creditors agree to accept an amount less than the face value of the debt.
Informal arrangements between creditors and a company where they agree to a rearrangement of liabilities are also possible. Receivership, whereby a secured creditor or the court can appoint an official receiver to either liquidate the assets or manage the business and its affairs until the secured creditors are paid in full or the decision is taken to close down the business. A creditor’s voluntary winding up involves the company’s directors and creditors resolving to wind up the company. A liquidator realises the company’s assets and distributes them among the creditors in order of priority, investigates the company and makes a report to the ASIC. (Hingston, 2001 p176)
Part X arrangements under the Bankruptcy Act have now become Personal Insolvency Agreements. Other arrangements include Part IX debt agreements and Part IV bankruptcy. Each has its advantages and disadvantages and the circumstance of each case will dictate which to use.
Irrespective of whether or not the creditors are paid out, the Australian Taxation Office requires the business to apply for cancellation of registration for GST within 21 days from cessation of trading. If the business has an ABN the ATO must be informed within 28 days to ensure changes are made to the details shown on the Australian Business Registrar. If a change in business structure is made to create a new entity an application for a new ABN must be made. (Australian Taxation Office, 2005)
The most important measure a small business can take to avoid insolvency is the same measure it needs to achieve success and that is the production and periodic maintenance of a business plan particularly including the financial statements. (Ernst and Young, 2005) The business plan demonstrates to outsiders the rational, organised process for operating the business and justifies its existence. (Austrade, 2005)
The business plan should contain:
Executive summary: explain succinctly what the business does and how it will use investor funds.
The opportunity: identify the problem your product will solve for the market, speaking in terms of customer needs.
The solution: outline your business proposition.
Market research: detail your understanding of the market and its trends.
Sales strategy: explain your proposed model for sales and distribution, including pricing strategy.
Intellectual property: set out details of any patents, trade secrets or other competitive advantages enjoyed by your business or its competitors.
Government regulation: outline any applicable government stipulations that might affect the business.
Exit/liquidity strategy: assuming all goes well; enumerate the potential returns for prospective investors.
People: provide details of key employees, advisors and other strategic personnel.
Financials: include full financial details, including a capitalisation chart, income statements, balance sheets, cash flows and shareholder structure.
Appendices: append any relevant technical or supplementary material. (Austrade, 2005)
By updating the business plan regularly it is possible to identify earlier some of the reasons small businesses stumble and be in a position to implement solutions to rectify the situation.
References
AMP & NATSEM (2005) AMP.NATSEM report on small business http://www.amp.com.au/group/3column/0,2449,CH12051%255FS13,
00.html (Website accessed 26/8/05)
Australian Bureau of Statistics (2001) Small Business in
Australia 2001 No 1321.0 p78
Australian Bureau of Statistics (2005) Small Business in
Australia http://opac.library.usyd.edu.au/search/Xsmall+
business++in+australia&searchscope=3&SORT=A/Xsmall+
business++
in+australia&searchscope=3&SORT=A&extended=0/13%
2C27%2C27%2CB/l856&FF=Xsmall%2Bbusiness%2B%2Bin%2Baustra
lia%26searchscope%3D3%26SORT%3DA%26extended%3D0&20%2
C20%2C%2C1%2C0 (website accessed 9/8/05)
Austrade (2005) Australian Governmenthttp://www.austrade.
gov.au/IT/layout/0,,0_S4-1_wqcrz11-2_-3_PWB13829253-4_97j
6iz3-5_-6_-7_,00.html (website accessed 24/8/05)
Australian Securities and Investment Commission (2005) ‘
Information about Insolvency and Liquidations’http://www.asic.gov.au/asic/asic_infoco.nsf/
byheadline/Insolvency+and+liquidators+homepage?openDocume
nt (website accessed 10/8/05)
Australian Securities and Investment Commission (2005a)
Bankruptcy and Personal Insolvency Agreements
http://www.asic.gov.au/asic/asic_infoco.nsf/byheadline/Ban
kruptcy+and+Pers
nal+Insolvency+Agreements?openDocument (Website accessed
24/8/05)
Bickerdyke, Ian et. al., (2000) Business failure and change:
an Australian
perspective, Productivity Commission, 2000.
Busch, P (1997) Starting and running a small business in
Australia. McGraw-Hill Australia
Companies and Securities Advisory Committee, (1997)
Voluntary insolvency
administration: discussion paper
Ernst and Young (2005) ‘How to prepare a business plan’
http://66.102.7.104/search?q=cache:Q5uJHHhjq0UJ:www.ey.
com/global/download.nsf/
Australia/How_to_Create_a_Business_Plan/%24file/Busplan.PDF+business+plan+production+in+australia
&hl=en (Website accessed 24/8/05)
Finch, V (2002)Corporate insolvency law : perspectives
and principles Cambridge University Press, Cambridge
Hingston, P(2001)Starting your business Dorling Kindersley
Insolvency and Trustee Service Australia, (2004) Inspector
Generals Annual Report 2004 http://www.itsa.gov.au/dir228/
itsaweb.nsf/docindex/About%20Us->Publications->Annual%20
Documents/$FILE/I-G_Annual_04.pdf?OpenElement
(Website Accessed 27/8/05)
Insolvency and Trustee Service Australia, (2005).
http://www.itsa.gov.au
(website accessed 14/8/05)
Jones, E. (2005) Lecture notes Telstra 1995 Survey.
(Accessed 29/8/05)
Keay, A and Murray M (2002) Insolvency : personal and
corporate law and practice / Rozelle, N.S.W. : Lawbook Co.
Meredith, G (1992). Small business management in
Australia McGraw-Hill, Sydney 1988.
OECD (1998) Science Technology and Industry
Outlook 1998 Organisation for Economic
Co-operation and Development Paris
Parliamentary Joint Committee on Corporations
and Financial Services
(2004)Corporate Insolvency Law: a Stocktake,
June 2004, Ch.2.
http://www.aph.gov.au (website accessed 24/8/05)
Saturday, September 10, 2005
Tuesday, September 06, 2005
A measure, but not of wellbeing
September 7, 2005
Gross domestic product calculations put too much spin on society's progress, writes Ross Gittins.
Today is one of the biggest days in the economists' year. Today economists get to see what we've come to think of as the result of all our labour, the bottom line of the grandly named "national accounts". At 11.30am we find out by how much gross domestic product grew during the three months to the end of June.
GDP is the value of all the goods and services produced during the period, which is also (roughly speaking) the amount of income all of us earnt.
Although you can never predict these things with any certainty, the tipping is that GDP will have grown by about 1.2 per cent in real terms. If so, there'll be great rejoicing. It will be a sign the economy's rate of growth is picking up from its recent slow patch.
There's just one problem. As every greenie will assure you, GDP is a lousing measure of progress. One glaring weakness is that it ignores all the work and production that doesn't involve the exchange of money. So all the goods and services we produce in our homes don't get counted. Nor does all the voluntary work people do.
When you cook a meal for yourself, it doesn't get counted. But when you eat out, or eat take-away, it does. When you clean your house it doesn't count, but when you pay someone else to, it does.
This means the long-standing trend for married women to return to paid work - and then pay others to do some of their housework - has caused GDP to exaggerate the true increase in the production of goods and services and overstate the degree of progress society has made.
Another weakness of GDP is that it includes "defensive expenditures". When the build up of noise in your street prompts you to get your windows double glazed, that counts as a plus with no minus - even though you're no better off than you were before the traffic got bad.
When someone has a road accident, the cost of repairing cars and bodies counts as a plus, while the damage to property, the pain, the disruption and any loss of life are all ignored.
A third weakness is that GDP ignores all the costs to the environment generated by economic activity: the depletion of natural resources, the destruction of species, the rubbish, the pollution and the greenhouse gas emissions. If these limitations of GDP surprise you, they don't surprise economists, who point out that GDP measures our income, and while traffic noise and road accidents do nothing to make us better off, it's undeniable that people earn income from installing double-glazing, repairing cars and repairing bodies.
The defence of GDP, in other words, is that it's a reasonable measure of what it was designed to measure: market production of goods and services and market incomes. It was never intended to measure human progress or society's wellbeing.
But this standard defence is too cute by half. The fact remains that politicians, business people and the media treat GDP as though it's a measure of wellbeing.
Our politicians - Labor just as much as the Liberals - are obsessed by the thing GDP measures, "economic growth". Governments' utterances are dominated by the growth they boast of having achieved. Oppositions' utterances are dominated by the growth governments have failed to achieve. Both sides' plans and promises are about what they'd do to hasten growth.
And the way economists promote economic growth - the way they're always urging us to change society so as to foster economic growth - makes it clear they, too, treat GDP as a measure of wellbeing.
How could we have fallen into this error? It's simple. We don't have a well-developed, regular measure of wellbeing, but we do have a well-developed measure of economic growth. It's that old story of human nature: in our efforts to improve things, we invariably focus on those things where progress can be measured while tending to ignore those where it can't.
The fact the economy is frequently and carefully measured does much to explain why governments focus so heavily on it and have economists as their most influential advisers.
In the United States, however, two leading members of the American Psychological Society - Professor Ed Diener of the University of Illinois and Professor Martin Seligman of the University of Pennsylvania - have launched a campaign to correct this imbalance.
They say there was a time when many basic needs were unmet and economic indicators were a good first approximation of how well a nation was doing. As nations become wealthier and basic needs are largely satisfied, however, economic indicators increasingly miss their target.
Taken alone, national economic indicators are now badly out of phase with national wellbeing. In many developed countries, real GDP per person has doubled or trebled over the past 50 years, while measures of satisfaction with life have been flat.
How could this be? Well, consider the "ill-being" that's grown alongside the growth in GDP: divorce, drug-taking, crime, suicide, depression and stress.
Diener and Seligman say the GDP figures should be supplemented by a regularly published "national wellbeing index" derived from a system of "national accounts of wellbeing". The key measure would be a regular national survey of people's life satisfaction ("taking things overall, how satisfied are you with your life?"), but specific aspects of life would also be surveyed: job satisfaction, physical health, mental disorders and social relationships.
This information would cost millions of dollars each year - but that would be tiny compared with the cost of all the present economic statistics.
And if it focused the attention of politicians, economists and the public directly on the true bottom line - wellbeing - rather than on the production and consumption that's such an unsatisfactory surrogate for it, our lives might be made a lot better.
Gross domestic product calculations put too much spin on society's progress, writes Ross Gittins.
Today is one of the biggest days in the economists' year. Today economists get to see what we've come to think of as the result of all our labour, the bottom line of the grandly named "national accounts". At 11.30am we find out by how much gross domestic product grew during the three months to the end of June.
GDP is the value of all the goods and services produced during the period, which is also (roughly speaking) the amount of income all of us earnt.
Although you can never predict these things with any certainty, the tipping is that GDP will have grown by about 1.2 per cent in real terms. If so, there'll be great rejoicing. It will be a sign the economy's rate of growth is picking up from its recent slow patch.
There's just one problem. As every greenie will assure you, GDP is a lousing measure of progress. One glaring weakness is that it ignores all the work and production that doesn't involve the exchange of money. So all the goods and services we produce in our homes don't get counted. Nor does all the voluntary work people do.
When you cook a meal for yourself, it doesn't get counted. But when you eat out, or eat take-away, it does. When you clean your house it doesn't count, but when you pay someone else to, it does.
This means the long-standing trend for married women to return to paid work - and then pay others to do some of their housework - has caused GDP to exaggerate the true increase in the production of goods and services and overstate the degree of progress society has made.
Another weakness of GDP is that it includes "defensive expenditures". When the build up of noise in your street prompts you to get your windows double glazed, that counts as a plus with no minus - even though you're no better off than you were before the traffic got bad.
When someone has a road accident, the cost of repairing cars and bodies counts as a plus, while the damage to property, the pain, the disruption and any loss of life are all ignored.
A third weakness is that GDP ignores all the costs to the environment generated by economic activity: the depletion of natural resources, the destruction of species, the rubbish, the pollution and the greenhouse gas emissions. If these limitations of GDP surprise you, they don't surprise economists, who point out that GDP measures our income, and while traffic noise and road accidents do nothing to make us better off, it's undeniable that people earn income from installing double-glazing, repairing cars and repairing bodies.
The defence of GDP, in other words, is that it's a reasonable measure of what it was designed to measure: market production of goods and services and market incomes. It was never intended to measure human progress or society's wellbeing.
But this standard defence is too cute by half. The fact remains that politicians, business people and the media treat GDP as though it's a measure of wellbeing.
Our politicians - Labor just as much as the Liberals - are obsessed by the thing GDP measures, "economic growth". Governments' utterances are dominated by the growth they boast of having achieved. Oppositions' utterances are dominated by the growth governments have failed to achieve. Both sides' plans and promises are about what they'd do to hasten growth.
And the way economists promote economic growth - the way they're always urging us to change society so as to foster economic growth - makes it clear they, too, treat GDP as a measure of wellbeing.
How could we have fallen into this error? It's simple. We don't have a well-developed, regular measure of wellbeing, but we do have a well-developed measure of economic growth. It's that old story of human nature: in our efforts to improve things, we invariably focus on those things where progress can be measured while tending to ignore those where it can't.
The fact the economy is frequently and carefully measured does much to explain why governments focus so heavily on it and have economists as their most influential advisers.
In the United States, however, two leading members of the American Psychological Society - Professor Ed Diener of the University of Illinois and Professor Martin Seligman of the University of Pennsylvania - have launched a campaign to correct this imbalance.
They say there was a time when many basic needs were unmet and economic indicators were a good first approximation of how well a nation was doing. As nations become wealthier and basic needs are largely satisfied, however, economic indicators increasingly miss their target.
Taken alone, national economic indicators are now badly out of phase with national wellbeing. In many developed countries, real GDP per person has doubled or trebled over the past 50 years, while measures of satisfaction with life have been flat.
How could this be? Well, consider the "ill-being" that's grown alongside the growth in GDP: divorce, drug-taking, crime, suicide, depression and stress.
Diener and Seligman say the GDP figures should be supplemented by a regularly published "national wellbeing index" derived from a system of "national accounts of wellbeing". The key measure would be a regular national survey of people's life satisfaction ("taking things overall, how satisfied are you with your life?"), but specific aspects of life would also be surveyed: job satisfaction, physical health, mental disorders and social relationships.
This information would cost millions of dollars each year - but that would be tiny compared with the cost of all the present economic statistics.
And if it focused the attention of politicians, economists and the public directly on the true bottom line - wellbeing - rather than on the production and consumption that's such an unsatisfactory surrogate for it, our lives might be made a lot better.
Sunday, August 28, 2005
Why labour market 'flexibility' can be bad
By Ross Gittins
August 29, 2005
MONDAY COMMENT
Why should governments prescribe the number of weeks' annual leave, the public holidays or the meal breaks workers must take? Why not permit workers to give up these conditions in return for higher wages?
Why not make dealings between bosses and workers more flexible? If bosses consider it worth their while to buy out these conditions, why prevent them from making an offer? If workers don't happen to attach much value to these conditions, why not let workers exchange them for cash if the price is acceptable?
That way, both employers and employees get more choice. How could that be a bad thing? How could governments know better than individuals what's in their best interests?
To conservative politicians, political libertarians and most economists, these arguments are highly persuasive. They're completely consistent with conventional economic analysis.
But I think they're misguided. The obvious objection concerns bargaining power. Conventional theory says that, in any transaction between a willing buyer and willing seller, both parties are left better off.
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The unspoken assumption, however, is that both sides have roughly equal bargaining power. But where one party has far more power than the other - such as where a boss bargains with an individual employee - the economists' model offers no assurance the weaker party will get a fair deal.
There's a less obvious objection, however, which deserves more attention. As the Anglican Archbishop of Sydney, Peter Jensen, implied in recent remarks, conventional economics is grounded in the political philosophy of individualism.
It's the interests of the individual that matter above all. In the economic decisions you and I make, we're completely uninfluenced by the attitudes and behaviour of the people around us (except, of course, to the extent that other people's behaviour influences the prices we face).
And this is as it should be. After all, how could any other person know better than you what purchase or activity would yield you greatest satisfaction? In particular, how could any government do a better job of spending your money than you could?
Such thinking is hugely influential among economists. It explains why most are passionate believers in small government - limited government spending and low taxation - why most are suspicious of government actions but defensive of private sector actions and why most economists favour deregulating the labour market.
But though few of them realise it, the economists' supreme faith in the superior wisdom of the individual is based on another assumption: that people are rational. That their decisions are always based on clear-headed self-interest.
It's because individuals are rational that governments can never out-guess their best interests.
Trouble is, the burgeoning school of behavioural economics has borrowed from a lot of psychological research to demonstrate convincingly that people are often anything but rational in their decision-making.
People regularly ignore any number of economists' rules: opportunity cost, the irrelevance of sunk costs, the fungibility of money and many more.
People are often inconsistent in the choices they make, are confused by too much choice, are unduly influenced by the way decisions are "framed", are susceptible to fads and fashions, are deeply concerned about fairness and are often led by their emotions to do silly things.
To quote just one example I noticed the other day, a study by David Laibson of Harvard University found that in a 401(k) retirement savings plan where the employer offered to match employees' contributions - but money could be withdrawn without penalty - half the employees didn't take advantage of the offer, forgoing matching contributions equivalent to 1.3 per cent of their annual pay.
And get the kicker: providing these people with specific information about the free lunch they were giving up failed to raise their contributions.
Of more direct relevance to the question of permitting bargaining over working conditions is the research of Matthew Rabin of the University of California at Berkeley.
His work confirms what economists should know from self-reflection (if they ever do it): almost all of us have trouble with self-control. We're always yielding to the temptation to eat or drink too much, skipping a visit to the gym, or not saving as much as we know we should.
In other words, we have a preference for immediate gratification. We over-indulge in activities with immediate rewards and delayed costs.
As part of this, people don't discount future events in the "time consistent" way economists assume they do. Rather, we apply a much higher discount rate to near events than to distant events.
Our "present selves" are always leading us to do things our "long-run selves" will regret. So, for instance, we're perfectly capable of agreeing to cash out our holidays because of all the things we could do with the money, then greatly regretting our foolishness in giving up our holidays.
Nor is there any reason to believe we can make rational judgments about our need for the rest and re-creation that annual leave, public holidays and meal breaks are intended to provide to keep us performing our jobs efficiently. And if workers can be short-sighted, so can bosses.
Recognising their problem with self-control, people often impose "commitment devices" on themselves so as to force themselves to behave in the way their long-term selves know they should.
These commitment devices often involve some cost, inconvenience or interest forgone. This suggests that, were workers asked to vote on whether the cashing out of working conditions should be permitted, more might opt for less choice than economists would expect. Workers might want to avoid having temptation put in their way.
Another finding of the behavioural economists is that people are more attracted to increases in their relative income than their absolute income. Humans, in other words, are highly rivalrous, always keen to improve their social standing.
This means people whose basic needs have been met are often attracted to conspicuous consumption: spending on clothes or cars or houses or boats that displays their superior status.
But spending on conspicuous consumption comes at the expense of inconspicuous consumption. Such as? Holidays.
A famous experiment with Harvard medical students found most would prefer to live in a world where they had more weeks of annual leave than they did at present, even though that world involved them having less leave than most other people.
In other words, annual leave was something they valued for its intrinsic attractions, not because it brought them status. But that makes it susceptible to being crowded out.
When you properly appreciate the fallibility of humans, you realise it's quite possible for governments to understand their best interests better than they do themselves.
Historically, governments imposed annual leave, public holidays and meal breaks on employers for good reason. It makes perfect sense for governments to insist that these costly conditions continue to be used for their intended purpose.
Ross Gittins is the Herald's Economics Editor.
August 29, 2005
MONDAY COMMENT
Why should governments prescribe the number of weeks' annual leave, the public holidays or the meal breaks workers must take? Why not permit workers to give up these conditions in return for higher wages?
Why not make dealings between bosses and workers more flexible? If bosses consider it worth their while to buy out these conditions, why prevent them from making an offer? If workers don't happen to attach much value to these conditions, why not let workers exchange them for cash if the price is acceptable?
That way, both employers and employees get more choice. How could that be a bad thing? How could governments know better than individuals what's in their best interests?
To conservative politicians, political libertarians and most economists, these arguments are highly persuasive. They're completely consistent with conventional economic analysis.
But I think they're misguided. The obvious objection concerns bargaining power. Conventional theory says that, in any transaction between a willing buyer and willing seller, both parties are left better off.
AdvertisementAdvertisement
The unspoken assumption, however, is that both sides have roughly equal bargaining power. But where one party has far more power than the other - such as where a boss bargains with an individual employee - the economists' model offers no assurance the weaker party will get a fair deal.
There's a less obvious objection, however, which deserves more attention. As the Anglican Archbishop of Sydney, Peter Jensen, implied in recent remarks, conventional economics is grounded in the political philosophy of individualism.
It's the interests of the individual that matter above all. In the economic decisions you and I make, we're completely uninfluenced by the attitudes and behaviour of the people around us (except, of course, to the extent that other people's behaviour influences the prices we face).
And this is as it should be. After all, how could any other person know better than you what purchase or activity would yield you greatest satisfaction? In particular, how could any government do a better job of spending your money than you could?
Such thinking is hugely influential among economists. It explains why most are passionate believers in small government - limited government spending and low taxation - why most are suspicious of government actions but defensive of private sector actions and why most economists favour deregulating the labour market.
But though few of them realise it, the economists' supreme faith in the superior wisdom of the individual is based on another assumption: that people are rational. That their decisions are always based on clear-headed self-interest.
It's because individuals are rational that governments can never out-guess their best interests.
Trouble is, the burgeoning school of behavioural economics has borrowed from a lot of psychological research to demonstrate convincingly that people are often anything but rational in their decision-making.
People regularly ignore any number of economists' rules: opportunity cost, the irrelevance of sunk costs, the fungibility of money and many more.
People are often inconsistent in the choices they make, are confused by too much choice, are unduly influenced by the way decisions are "framed", are susceptible to fads and fashions, are deeply concerned about fairness and are often led by their emotions to do silly things.
To quote just one example I noticed the other day, a study by David Laibson of Harvard University found that in a 401(k) retirement savings plan where the employer offered to match employees' contributions - but money could be withdrawn without penalty - half the employees didn't take advantage of the offer, forgoing matching contributions equivalent to 1.3 per cent of their annual pay.
And get the kicker: providing these people with specific information about the free lunch they were giving up failed to raise their contributions.
Of more direct relevance to the question of permitting bargaining over working conditions is the research of Matthew Rabin of the University of California at Berkeley.
His work confirms what economists should know from self-reflection (if they ever do it): almost all of us have trouble with self-control. We're always yielding to the temptation to eat or drink too much, skipping a visit to the gym, or not saving as much as we know we should.
In other words, we have a preference for immediate gratification. We over-indulge in activities with immediate rewards and delayed costs.
As part of this, people don't discount future events in the "time consistent" way economists assume they do. Rather, we apply a much higher discount rate to near events than to distant events.
Our "present selves" are always leading us to do things our "long-run selves" will regret. So, for instance, we're perfectly capable of agreeing to cash out our holidays because of all the things we could do with the money, then greatly regretting our foolishness in giving up our holidays.
Nor is there any reason to believe we can make rational judgments about our need for the rest and re-creation that annual leave, public holidays and meal breaks are intended to provide to keep us performing our jobs efficiently. And if workers can be short-sighted, so can bosses.
Recognising their problem with self-control, people often impose "commitment devices" on themselves so as to force themselves to behave in the way their long-term selves know they should.
These commitment devices often involve some cost, inconvenience or interest forgone. This suggests that, were workers asked to vote on whether the cashing out of working conditions should be permitted, more might opt for less choice than economists would expect. Workers might want to avoid having temptation put in their way.
Another finding of the behavioural economists is that people are more attracted to increases in their relative income than their absolute income. Humans, in other words, are highly rivalrous, always keen to improve their social standing.
This means people whose basic needs have been met are often attracted to conspicuous consumption: spending on clothes or cars or houses or boats that displays their superior status.
But spending on conspicuous consumption comes at the expense of inconspicuous consumption. Such as? Holidays.
A famous experiment with Harvard medical students found most would prefer to live in a world where they had more weeks of annual leave than they did at present, even though that world involved them having less leave than most other people.
In other words, annual leave was something they valued for its intrinsic attractions, not because it brought them status. But that makes it susceptible to being crowded out.
When you properly appreciate the fallibility of humans, you realise it's quite possible for governments to understand their best interests better than they do themselves.
Historically, governments imposed annual leave, public holidays and meal breaks on employers for good reason. It makes perfect sense for governments to insist that these costly conditions continue to be used for their intended purpose.
Ross Gittins is the Herald's Economics Editor.
Wednesday, August 17, 2005
Tax the rich! But how?
The Australian Council of Social Services released a report in October 2003 that succinctly captured the Australian attitude to the provision of social services by the government. It found a long term trend of declining concern about taxation but rising concern for issues such as health and education and a greater preparedness for taxes to rise to fund public services. It also found corporations and wealthy people are perceived as not paying their fair share of taxes and that this seems to undermine the willingness of the wider public to meet their tax commitments. (ACOSS Info 335, 2003). More recently research conducted by Roy Morgan found almost 90% of Australians would prefer the Government use the money to fix problems in housing, education and health rather than the muted $5 tax cut. (National Welfare Rights Network, 2004). The formation of the welfare state since 1945 has raised expectations for government intervention to achieve fiscal goals. In this paper I will describe how these goals have been re-defined by the interests of capital to make the incidence of tax heavier on workers and easier on those most able to manipulate the tax legislative regime by tax shifting and planning. Orthodox economics argues reducing income taxes will stimulate saving and investment whilst increasing efficiency and growth. I dispute this, using recent data, and feature compliance costs as the major inefficiency. Although consumption taxes widen the tax base and are more efficient to collect I will argue their introduction is problematic. I will draw on the work of the Evatt foundation and ACOSS to suggest reforms to the taxation system more in line with the wishes of the citizens as relayed by the surveys quoted above. The goal is a fairer tax system.
Serfs in medieval times resented paying taxes for a very good reason. The way the taxes were collected and the fact they saw little return. At the top of the tax chain stood the monarch and his court that enjoyed a lifestyle considerably better than any of his subjects. This fundamental perception of unfairness persists today. As Whiting (2000) has observed, successful taxation to redistribute wealth to achieve equity ‘ought to be a desirable good not a necessary evil’. There has to be an element of consent. There has to be a fairness argument for efficient taxation to be accepted by the taxed. This is essentially not about high tax versus low tax but what is fair tax. Treat people with different levels of income the same and treat equally different sources of income. This is a type of horizontal calculation compared to a vertical calculation which more favors the view good taxation generates greater equality. High income should be reduced to create a more stable society. The re-distributing of wealth is the object. For Kaldor the main issue is also to address inequality particularly through the principle of progressive taxation. Hayek disagreed with this progressive principle, arguing these taxes acted as a disincentive to improve monetary reward for effort. This view has been disputed in light of recent data.
Income distribution in the UK and Australia has shifted towards the higher income group in the last two decades.(Goodman and Webb, 1994., Jenkins, 1995 in Laramie, A. J. (2000) p184) However, not only have capitalists increased their income share, they have substantially increased their propensity to consume. (Laramie, A. J. (2000 p.185). Capitalists no longer seem to be behaving in the traditional capitalist manner and are increasingly substituting consumption for investment. Investment in the UK has leveled off whilst capitalist income has continued to grow strongly.
Capital has redefined fiscal policy to provide for low inflation in a moderate growth environment. To stabilize the economy around a zero trend rate of investment with a balanced budget (another new goal) requires the government to raise the tax rate on wage income or cut the tax rate on profits. The empirical evidence from the US suggests strongly that changes in tax rates on wage income have a much more potent effect on investment than changes in tax rates on profits. Thus, in practice, the fiscal burden of stabilization would be borne by the recipients of wage income but only if they are unable to shift their increased tax burden. (Laramie, A. J. 2000. p189)
This leads to some discussion on tax shifting. In many cases the incidence of the tax may be shifted from the initial impact to someone else. Taxes initially falling on businesses must eventually be shifted to individuals. The final burden may fall on consumers in the form of higher prices, on workers in the form of lower wages or on suppliers of other inputs in the form of lower prices or rent or on stockholders in the form of lower dividends. (Winfrey, J.C. 1998, p56). If corporation income taxes were paid by the firm’s owners the tax would be progressive. There is disagreement among economists as to who actually bears the burden however. Some studies claim that most corporation income tax is passed on to consumers in the form of higher prices. This would indicate the tax is regressive and it would indicate that increases would add to inflation. Other studies claim that corporations have not raised prices in response to increases, and therefore, the burden must reside with the owners. Although it is widely assumed that employers and employees both pay their designated parts of payroll tax, economists are nearly unanimous in their belief that employees bear the entire burden. The incidence of property taxes is also disputed. It is generally held that homeowners bear their part of the tax but that owners of rental housing are able to pass their burdens on in the form of higher rents. It is argued sales taxes and excise taxes are regressive. (Winfrey, J.C. 1998)
Two points about compliance costs are relatively well accepted and are not surprising. Firstly they tend to be much larger than the direct costs of the Australian Taxation Office. Secondly, compliance costs are usually regressive affecting small taxpayers and businesses to a much greater extent than large firms.
No matter what action was taken to reduce compliance costs, these features may persist. Some reductions in compliance costs are likely to be achievable by focusing not only on the complexity of tax law and the operations of the ATO, but also on the response of different types of businesses to prevailing tax laws and rules. This could help identify management structures and characteristics that are associated with lower tax compliance costs. Planning costs which are incurred by taxpayers to reduce tax liabilities show up as tax compliance costs. (Pope, 1993). Planning costs have the effect of increasing compliance costs and reducing total taxation revenues, thus increasing the ratio of compliance costs to total taxation paid. Indeed, the relatively high tax compliance costs in Australia are likely to result in part from the complexity of the tax system providing scope to minimize tax liabilities by incurring substantial planning costs. The obvious way to reduce planning costs is to reduce the scope for tax planning to minimize tax liabilities.
Voluntary compliance costs are incurred for a variety of reasons, including the complexity of the tax system and because of the large number of deductions that are currently available. These costs could be reduced, in part, by continuation and extension of current initiatives to simplify tax regulations.
Causes of compliance costs include:
• Increasingly complex economic activity
• The design of tax law is often constrained by equity considerations (for example complex transitional provisions preserving pre-existing benefits)
• The tax system is being used to achieve a variety of other non-tax objectives (for example, education and industry assistance)
• Ad-hoc development of tax law over time
• Governments prescribe in legislation arrangements that will apply in most circumstances, rather than allowing a large measure of bureaucratic discretion. This increases the transparency and certainty of the tax system. However it also increases its complexity
• The ongoing need to develop, draft and refine complex anti-avoidance provisions to close off tax minimization practices. (Rimmer, S. & Wilson, S. 1996)
This writer agrees the ultimate test of taxes is not whether they benefit the economy or some section of the economy but whether they promote a better society. The tax system should be structured in ways which will raise revenue fairly. A caring attitude not only develops social cohesiveness but also assists economic performance, not least in facilitating ongoing structural change. The tax system should be uncomplicated and with general perceptions that the arrangements are basically fair will help to deliver high levels of compliance. (Evatt Foundation Group. 1999 p6)
Income taxation is the logical place to look for sustained revenue growth. It is currently the largest generator of government revenue contributing about 70 percent of total Australian Commonwealth Government revenues in the last decade. About 50 percent of this is income tax collected from individuals. It follows the tax reform process should address the factors contributing to the erosion of this tax base. The myriad of tax benefits which individuals and business derive through tax exemptions, deductions, rebates and other concessions are as real as any provided through direct expenditure programs but they tend to be less transparent and subject to less public and private scrutiny than direct expenditures. These supports are viewed as incentives whereas supports through the welfare system are viewed as handouts. Substantial tax expenditures are provided to vested interests in mining and agriculture for narrow political and ideological gains. It is suggested tax expenditures in each functional area of the economy should be combined with direct expenditure in the same area and relevant ministers could be pressed to justify their combined outlay and tax expenditure.
In the interests of fairness the current preferential tax status of capital gains – which benefits mainly high income earners-should not be allowed to continue. With professional help, income streams are being readily converted into capital gains streams which attract preferential treatment. Gains from investments in property, including the family home, dividends, sale of shares and the roll-over of small businesses should be taxed as income.
Negative gearing should be abolished. This form of tax avoidance has grown dramatically in the last decades. Typically used to claim deductions for expenses associated with income producing properties against income from other sources, it facilitates tax shifting into the future and to the lower capital gains tax rate. It benefits the higher income groups and according to ACOSS (2004) does nothing to provide low rental properties, the reason often cited for its continuance.
The absence of taxes on net wealth and wealth transfers in Australia needs to be addressed. One of the few countries in the world not to have such taxes, Australia exhibits a case on equity grounds for such a tax.
All work related expenses of employees should be disallowed. It is expected employers would move to pick up the legitimate expenses of employees and adjust their take home pay, leaving both parties unaffected. Deductions for self-education expenses should be disallowed. More direct and better targeted measures are needed to ensure life-long learning in the community.
The Pay-As-You-Earn system of taxation is being eroded reflecting several factors. Deficiencies in the taxation of fringe benefits, contracting out and interposing a company or trust are the main culprits. All these techniques to minimize, delay or avoid income tax should be banned.
The major problem with the perception of the tax system as unfair is in the provision of artificial tax minimization schemes to those high income and wealthy individuals best able to use them. Using private companies and trusts offer flexible mechanisms for income splitting and shifting income and losses to the best tax advantage. It also facilitates hiding true asset ownership which is one of the current tests for welfare recipients. This promotes middle class welfare at the expense of those who truly need it.
Poverty traps have resulted from the increase in complexity of the tax system over the last decades. This complexity is the result of labor market changes including an increase participation of women, decentralization and deregulation of the workplace, expansion of part-time and part-pay arrangements, downwards pressure on minimum pay rates and increased unemployment. The number of social security and tax based assistance programs has doubled, all major social transfer payments have been subject to increased targeting and composite wage-tax-social income packages were negotiated under the Accords of the 1980’s and the early 1990’s. Many people now receive a composite income made up of wages and social transfers. As a persons hours of employment increase, the combination of taxation of the market income and the social transfer withdrawal imposes high effective marginal tax rates. This can lead to tax rates of over 100% in some cases. Perhaps the most pernicious result of this inequality is the number of recipients forced to work in the underground economy. This has further revenue implications from the avoidance of income tax but more importantly adds to the perception of unfairness held by those caught by these traps and from their relatives, friends and members of the community alerted by the media.
Individual income tax rates and thresholds needs to be reviewed. Given the measures outlined above broadens the income tax base and additional revenue could be expected from ongoing economic growth, bracket creep and enhanced compliance it is appropriate to consider reductions in rates and increased income banding. The only recipients for such consideration should be low income groups further demonstrating real progress towards a fairer tax system. In contrast, Keating argues for an increase in rates across the board. He says the present taxation ceiling is essentially politically determined, and the economic case against an increase in the level of taxation is not strong. The principal problem with our arbitrary tax ceiling is that it does not reflect any serious consideration of the future needs of the country and their relative priority. In these circumstances if the present size of government was considered to be about right twenty years ago, it should not altogether be a surprise that taxation might rise in future, given the nature of the challenges that our society is facing. Indeed our willingness to pay for some increase in the size of government might well influence our capacity to increase employment participation and achieve the desired rate of future economic growth.
The problem with continuing the present limits to taxation and spending is that we risk fooling ourselves that these limits are sacrosanct and that they are capable of reflecting our future priorities. But the reality is that by limiting taxation from the outset, without any serious consideration of what it implies, we are more likely to distort our priorities. (Keating, M. 2004)
There is no compelling evidence lowering the company tax rate increases the desirability of Australia as a destination for investment. Comparisons with other low tax jurisdictions such as in Asia are specious because international companies are in a position to manage their affairs with profit shifting, transfer pricing, numerous exemptions, concessions and special rules. Australia should not be in a race to the bottom as companies shop for the best option in tax reduction techniques particularly given the increased dominance of multi-nationals in the global economy.
More needs to be said about the broadening of the indirect tax base. The introduction of a value added tax in the form of a Goods and Services Tax was made on the argument it provided a simpler and cheaper tax collecting device because it effectively turned every consumer into a tax collector and it is supposed to catch tax lost through income tax revenue reductions. The major equity argument against such a tax is it is regressive, hitting the least well off the hardest. A switch to GST, it is suggested, might encourage a little more saving, because income taxes tend to reduce the net rate of return on saving while consumption taxes have no impact on this rate of return. As yet there is no evidence to support this view. On the contrary, Canadian experience has demonstrated a ballooning of the cash economy. For a lot of people the GST is just another tax to dodge with the wealthiest more adept than poor people in doing so. On the other hand the battle to expand the income tax base in the face of a lack of political will and popular support combined with the demographic imperative of a decline in the number of potential taxpayers and an increase in the number of older citizens may make some move in this direction inevitable. It can never be the preferred option when fairness is the main objective of the tax system. (Evatt Foundation Group. 1999)
All proponents agree on the need to compensate low income earners for the regressive nature of a consumption tax. Consumption based compensation is not straightforward. Like the rest of the social security system should the compensation be family based or individual. Individual consumption patterns change and are expensive to track. Family based compensation faces intra-family redistribution problems. Groups like the self-employed and low income young people would not be easy to compensate through the existing tax and transfer mechanism. Other difficulties arise for part-rate pensioners and beneficiaries in which the scope and adequacy of compensation arrangements conflict with cost and equity considerations. Unfortunately some groups will miss out on full compensation in a compromise that stops overcompensation and will not be expensive. (Saunders, P. and Whiteford, P. (1990 p1)
Regressive taxes more effectively increase the state funding capacity that results from flat rates and a tax base resistant to erosion. Politics preclude an efficient direct transfer from the rich to the poor and needy who lack a majority support, and prevent progressive taxation from raising large revenues by increasing loopholes and special tax measures. At the same time, however, the formation of the state funding capacity is a historical product and path-dependent upon a peculiar pattern of tax policy development. Among the existing industrial democracies, the early institutionalization of regressive taxes is a critical cause of a self-enforcing process of high tax and high welfare: both policy makers and the public accepted high taxes to finance high welfare after the expansion of state funding capacity during the high growth of the 1950’s and 1960’s. (Kato, J. (2003)
This paper has detailed a substantial overhaul of the tax system in line with suggestions from the Evatt Foundation and ACOSS. I argue for a re-emphasis on income taxes in the interests of fairness and efficiency. Compliance costs need to be reduced. Whilst recognizing the need for a consumption tax work on compensatory redistributions needs to be done. With Keating, I present an argument for higher tax rates and suggest urgent attention needs to be paid in the interests of a more equitable society.
References
ACOSS Info 351, 2003) Taxation, Fairness and Public Opinion. Accessed April 14 2004
http://coss.net.au/news/upload/info351_tax_fairness_1.doc
ACOSS (2004) ‘ACOSS calls for tax loopholes to be plugged’ Matt Wade, Sydney Morning Herald. Website accessed 12 April 2004
http://www.smh.com.au/articles/2004/04/12/
1081621896896.html
Evatt Foundation Group. (1999) Bernie Fraser, Trevor Boucher, John Freeland, Professor Bob Gregory, Alison McClelland. A Fair and Adequate Tax System. Evatt Foundation. Sydney
Goodman, A and Webb, S (1994), ‘For richer, for poorer: the changing distribution of income in the UK. 1961-1991’. Fiscal Studies, 15 (4), 29-62
Jenkins, S.P. (1995), ‘Accounting for inequality trends: decomposition analyses for the UK, 1971-1986 Economica, 62,29-63
Kaldor, N. ‘Taxation for Economic Development’
Kato, J. (2003) Regressive Taxation and the Welfare State. Cambridge University Press. Cambridge.
Keating, M. (2004) The Case for Increased Taxation. Academy of the Social Sciences in Australia. Canberra
Laramie, Anthony J (2000.) A dynamic theory of taxation : integrating Kalecki into modern public finance Edward Elgar Publishing Cheltenham, UK
Leibfritz, W., Thornton, J. and Bibbee, A. (1997) Taxation and Economic Performance. Economics Department Working Papers. No. 176. OECD. Paris.
National Welfare Rights Network (2004) website accessed 2 May 2004
http://www.welfarerights.org.au
Pope, J. Fayle, R and Chen, D.L.(1993) The Compliance Costs of Employment Related Taxation in Australia. Australian Tax Research Foundation. Sydney.
Rimmer, S. & Wilson, S. (1996) Compliance Costs of Taxation in Australia. Office of Regulation Review. Industry Commission. Canberra.
Saunders, P. and Whiteford, P. (1990) Compensating low income groups for indirect tax Reforms. Social Policy Research. UNSW. Australia
Winfrey, J.C. (1998) Social Issues: The Ethics and Economics of Taxes and Public Programs. Oxford University Press. Oxford.
Whiting, R. (2000) Introduction: taxation and political debate in The Labour Party and Taxation, Cambridge University Press.
Serfs in medieval times resented paying taxes for a very good reason. The way the taxes were collected and the fact they saw little return. At the top of the tax chain stood the monarch and his court that enjoyed a lifestyle considerably better than any of his subjects. This fundamental perception of unfairness persists today. As Whiting (2000) has observed, successful taxation to redistribute wealth to achieve equity ‘ought to be a desirable good not a necessary evil’. There has to be an element of consent. There has to be a fairness argument for efficient taxation to be accepted by the taxed. This is essentially not about high tax versus low tax but what is fair tax. Treat people with different levels of income the same and treat equally different sources of income. This is a type of horizontal calculation compared to a vertical calculation which more favors the view good taxation generates greater equality. High income should be reduced to create a more stable society. The re-distributing of wealth is the object. For Kaldor the main issue is also to address inequality particularly through the principle of progressive taxation. Hayek disagreed with this progressive principle, arguing these taxes acted as a disincentive to improve monetary reward for effort. This view has been disputed in light of recent data.
Income distribution in the UK and Australia has shifted towards the higher income group in the last two decades.(Goodman and Webb, 1994., Jenkins, 1995 in Laramie, A. J. (2000) p184) However, not only have capitalists increased their income share, they have substantially increased their propensity to consume. (Laramie, A. J. (2000 p.185). Capitalists no longer seem to be behaving in the traditional capitalist manner and are increasingly substituting consumption for investment. Investment in the UK has leveled off whilst capitalist income has continued to grow strongly.
Capital has redefined fiscal policy to provide for low inflation in a moderate growth environment. To stabilize the economy around a zero trend rate of investment with a balanced budget (another new goal) requires the government to raise the tax rate on wage income or cut the tax rate on profits. The empirical evidence from the US suggests strongly that changes in tax rates on wage income have a much more potent effect on investment than changes in tax rates on profits. Thus, in practice, the fiscal burden of stabilization would be borne by the recipients of wage income but only if they are unable to shift their increased tax burden. (Laramie, A. J. 2000. p189)
This leads to some discussion on tax shifting. In many cases the incidence of the tax may be shifted from the initial impact to someone else. Taxes initially falling on businesses must eventually be shifted to individuals. The final burden may fall on consumers in the form of higher prices, on workers in the form of lower wages or on suppliers of other inputs in the form of lower prices or rent or on stockholders in the form of lower dividends. (Winfrey, J.C. 1998, p56). If corporation income taxes were paid by the firm’s owners the tax would be progressive. There is disagreement among economists as to who actually bears the burden however. Some studies claim that most corporation income tax is passed on to consumers in the form of higher prices. This would indicate the tax is regressive and it would indicate that increases would add to inflation. Other studies claim that corporations have not raised prices in response to increases, and therefore, the burden must reside with the owners. Although it is widely assumed that employers and employees both pay their designated parts of payroll tax, economists are nearly unanimous in their belief that employees bear the entire burden. The incidence of property taxes is also disputed. It is generally held that homeowners bear their part of the tax but that owners of rental housing are able to pass their burdens on in the form of higher rents. It is argued sales taxes and excise taxes are regressive. (Winfrey, J.C. 1998)
Two points about compliance costs are relatively well accepted and are not surprising. Firstly they tend to be much larger than the direct costs of the Australian Taxation Office. Secondly, compliance costs are usually regressive affecting small taxpayers and businesses to a much greater extent than large firms.
No matter what action was taken to reduce compliance costs, these features may persist. Some reductions in compliance costs are likely to be achievable by focusing not only on the complexity of tax law and the operations of the ATO, but also on the response of different types of businesses to prevailing tax laws and rules. This could help identify management structures and characteristics that are associated with lower tax compliance costs. Planning costs which are incurred by taxpayers to reduce tax liabilities show up as tax compliance costs. (Pope, 1993). Planning costs have the effect of increasing compliance costs and reducing total taxation revenues, thus increasing the ratio of compliance costs to total taxation paid. Indeed, the relatively high tax compliance costs in Australia are likely to result in part from the complexity of the tax system providing scope to minimize tax liabilities by incurring substantial planning costs. The obvious way to reduce planning costs is to reduce the scope for tax planning to minimize tax liabilities.
Voluntary compliance costs are incurred for a variety of reasons, including the complexity of the tax system and because of the large number of deductions that are currently available. These costs could be reduced, in part, by continuation and extension of current initiatives to simplify tax regulations.
Causes of compliance costs include:
• Increasingly complex economic activity
• The design of tax law is often constrained by equity considerations (for example complex transitional provisions preserving pre-existing benefits)
• The tax system is being used to achieve a variety of other non-tax objectives (for example, education and industry assistance)
• Ad-hoc development of tax law over time
• Governments prescribe in legislation arrangements that will apply in most circumstances, rather than allowing a large measure of bureaucratic discretion. This increases the transparency and certainty of the tax system. However it also increases its complexity
• The ongoing need to develop, draft and refine complex anti-avoidance provisions to close off tax minimization practices. (Rimmer, S. & Wilson, S. 1996)
This writer agrees the ultimate test of taxes is not whether they benefit the economy or some section of the economy but whether they promote a better society. The tax system should be structured in ways which will raise revenue fairly. A caring attitude not only develops social cohesiveness but also assists economic performance, not least in facilitating ongoing structural change. The tax system should be uncomplicated and with general perceptions that the arrangements are basically fair will help to deliver high levels of compliance. (Evatt Foundation Group. 1999 p6)
Income taxation is the logical place to look for sustained revenue growth. It is currently the largest generator of government revenue contributing about 70 percent of total Australian Commonwealth Government revenues in the last decade. About 50 percent of this is income tax collected from individuals. It follows the tax reform process should address the factors contributing to the erosion of this tax base. The myriad of tax benefits which individuals and business derive through tax exemptions, deductions, rebates and other concessions are as real as any provided through direct expenditure programs but they tend to be less transparent and subject to less public and private scrutiny than direct expenditures. These supports are viewed as incentives whereas supports through the welfare system are viewed as handouts. Substantial tax expenditures are provided to vested interests in mining and agriculture for narrow political and ideological gains. It is suggested tax expenditures in each functional area of the economy should be combined with direct expenditure in the same area and relevant ministers could be pressed to justify their combined outlay and tax expenditure.
In the interests of fairness the current preferential tax status of capital gains – which benefits mainly high income earners-should not be allowed to continue. With professional help, income streams are being readily converted into capital gains streams which attract preferential treatment. Gains from investments in property, including the family home, dividends, sale of shares and the roll-over of small businesses should be taxed as income.
Negative gearing should be abolished. This form of tax avoidance has grown dramatically in the last decades. Typically used to claim deductions for expenses associated with income producing properties against income from other sources, it facilitates tax shifting into the future and to the lower capital gains tax rate. It benefits the higher income groups and according to ACOSS (2004) does nothing to provide low rental properties, the reason often cited for its continuance.
The absence of taxes on net wealth and wealth transfers in Australia needs to be addressed. One of the few countries in the world not to have such taxes, Australia exhibits a case on equity grounds for such a tax.
All work related expenses of employees should be disallowed. It is expected employers would move to pick up the legitimate expenses of employees and adjust their take home pay, leaving both parties unaffected. Deductions for self-education expenses should be disallowed. More direct and better targeted measures are needed to ensure life-long learning in the community.
The Pay-As-You-Earn system of taxation is being eroded reflecting several factors. Deficiencies in the taxation of fringe benefits, contracting out and interposing a company or trust are the main culprits. All these techniques to minimize, delay or avoid income tax should be banned.
The major problem with the perception of the tax system as unfair is in the provision of artificial tax minimization schemes to those high income and wealthy individuals best able to use them. Using private companies and trusts offer flexible mechanisms for income splitting and shifting income and losses to the best tax advantage. It also facilitates hiding true asset ownership which is one of the current tests for welfare recipients. This promotes middle class welfare at the expense of those who truly need it.
Poverty traps have resulted from the increase in complexity of the tax system over the last decades. This complexity is the result of labor market changes including an increase participation of women, decentralization and deregulation of the workplace, expansion of part-time and part-pay arrangements, downwards pressure on minimum pay rates and increased unemployment. The number of social security and tax based assistance programs has doubled, all major social transfer payments have been subject to increased targeting and composite wage-tax-social income packages were negotiated under the Accords of the 1980’s and the early 1990’s. Many people now receive a composite income made up of wages and social transfers. As a persons hours of employment increase, the combination of taxation of the market income and the social transfer withdrawal imposes high effective marginal tax rates. This can lead to tax rates of over 100% in some cases. Perhaps the most pernicious result of this inequality is the number of recipients forced to work in the underground economy. This has further revenue implications from the avoidance of income tax but more importantly adds to the perception of unfairness held by those caught by these traps and from their relatives, friends and members of the community alerted by the media.
Individual income tax rates and thresholds needs to be reviewed. Given the measures outlined above broadens the income tax base and additional revenue could be expected from ongoing economic growth, bracket creep and enhanced compliance it is appropriate to consider reductions in rates and increased income banding. The only recipients for such consideration should be low income groups further demonstrating real progress towards a fairer tax system. In contrast, Keating argues for an increase in rates across the board. He says the present taxation ceiling is essentially politically determined, and the economic case against an increase in the level of taxation is not strong. The principal problem with our arbitrary tax ceiling is that it does not reflect any serious consideration of the future needs of the country and their relative priority. In these circumstances if the present size of government was considered to be about right twenty years ago, it should not altogether be a surprise that taxation might rise in future, given the nature of the challenges that our society is facing. Indeed our willingness to pay for some increase in the size of government might well influence our capacity to increase employment participation and achieve the desired rate of future economic growth.
The problem with continuing the present limits to taxation and spending is that we risk fooling ourselves that these limits are sacrosanct and that they are capable of reflecting our future priorities. But the reality is that by limiting taxation from the outset, without any serious consideration of what it implies, we are more likely to distort our priorities. (Keating, M. 2004)
There is no compelling evidence lowering the company tax rate increases the desirability of Australia as a destination for investment. Comparisons with other low tax jurisdictions such as in Asia are specious because international companies are in a position to manage their affairs with profit shifting, transfer pricing, numerous exemptions, concessions and special rules. Australia should not be in a race to the bottom as companies shop for the best option in tax reduction techniques particularly given the increased dominance of multi-nationals in the global economy.
More needs to be said about the broadening of the indirect tax base. The introduction of a value added tax in the form of a Goods and Services Tax was made on the argument it provided a simpler and cheaper tax collecting device because it effectively turned every consumer into a tax collector and it is supposed to catch tax lost through income tax revenue reductions. The major equity argument against such a tax is it is regressive, hitting the least well off the hardest. A switch to GST, it is suggested, might encourage a little more saving, because income taxes tend to reduce the net rate of return on saving while consumption taxes have no impact on this rate of return. As yet there is no evidence to support this view. On the contrary, Canadian experience has demonstrated a ballooning of the cash economy. For a lot of people the GST is just another tax to dodge with the wealthiest more adept than poor people in doing so. On the other hand the battle to expand the income tax base in the face of a lack of political will and popular support combined with the demographic imperative of a decline in the number of potential taxpayers and an increase in the number of older citizens may make some move in this direction inevitable. It can never be the preferred option when fairness is the main objective of the tax system. (Evatt Foundation Group. 1999)
All proponents agree on the need to compensate low income earners for the regressive nature of a consumption tax. Consumption based compensation is not straightforward. Like the rest of the social security system should the compensation be family based or individual. Individual consumption patterns change and are expensive to track. Family based compensation faces intra-family redistribution problems. Groups like the self-employed and low income young people would not be easy to compensate through the existing tax and transfer mechanism. Other difficulties arise for part-rate pensioners and beneficiaries in which the scope and adequacy of compensation arrangements conflict with cost and equity considerations. Unfortunately some groups will miss out on full compensation in a compromise that stops overcompensation and will not be expensive. (Saunders, P. and Whiteford, P. (1990 p1)
Regressive taxes more effectively increase the state funding capacity that results from flat rates and a tax base resistant to erosion. Politics preclude an efficient direct transfer from the rich to the poor and needy who lack a majority support, and prevent progressive taxation from raising large revenues by increasing loopholes and special tax measures. At the same time, however, the formation of the state funding capacity is a historical product and path-dependent upon a peculiar pattern of tax policy development. Among the existing industrial democracies, the early institutionalization of regressive taxes is a critical cause of a self-enforcing process of high tax and high welfare: both policy makers and the public accepted high taxes to finance high welfare after the expansion of state funding capacity during the high growth of the 1950’s and 1960’s. (Kato, J. (2003)
This paper has detailed a substantial overhaul of the tax system in line with suggestions from the Evatt Foundation and ACOSS. I argue for a re-emphasis on income taxes in the interests of fairness and efficiency. Compliance costs need to be reduced. Whilst recognizing the need for a consumption tax work on compensatory redistributions needs to be done. With Keating, I present an argument for higher tax rates and suggest urgent attention needs to be paid in the interests of a more equitable society.
References
ACOSS Info 351, 2003) Taxation, Fairness and Public Opinion. Accessed April 14 2004
http://coss.net.au/news/upload/info351_tax_fairness_1.doc
ACOSS (2004) ‘ACOSS calls for tax loopholes to be plugged’ Matt Wade, Sydney Morning Herald. Website accessed 12 April 2004
http://www.smh.com.au/articles/2004/04/12/
1081621896896.html
Evatt Foundation Group. (1999) Bernie Fraser, Trevor Boucher, John Freeland, Professor Bob Gregory, Alison McClelland. A Fair and Adequate Tax System. Evatt Foundation. Sydney
Goodman, A and Webb, S (1994), ‘For richer, for poorer: the changing distribution of income in the UK. 1961-1991’. Fiscal Studies, 15 (4), 29-62
Jenkins, S.P. (1995), ‘Accounting for inequality trends: decomposition analyses for the UK, 1971-1986 Economica, 62,29-63
Kaldor, N. ‘Taxation for Economic Development’
Kato, J. (2003) Regressive Taxation and the Welfare State. Cambridge University Press. Cambridge.
Keating, M. (2004) The Case for Increased Taxation. Academy of the Social Sciences in Australia. Canberra
Laramie, Anthony J (2000.) A dynamic theory of taxation : integrating Kalecki into modern public finance Edward Elgar Publishing Cheltenham, UK
Leibfritz, W., Thornton, J. and Bibbee, A. (1997) Taxation and Economic Performance. Economics Department Working Papers. No. 176. OECD. Paris.
National Welfare Rights Network (2004) website accessed 2 May 2004
http://www.welfarerights.org.au
Pope, J. Fayle, R and Chen, D.L.(1993) The Compliance Costs of Employment Related Taxation in Australia. Australian Tax Research Foundation. Sydney.
Rimmer, S. & Wilson, S. (1996) Compliance Costs of Taxation in Australia. Office of Regulation Review. Industry Commission. Canberra.
Saunders, P. and Whiteford, P. (1990) Compensating low income groups for indirect tax Reforms. Social Policy Research. UNSW. Australia
Winfrey, J.C. (1998) Social Issues: The Ethics and Economics of Taxes and Public Programs. Oxford University Press. Oxford.
Whiting, R. (2000) Introduction: taxation and political debate in The Labour Party and Taxation, Cambridge University Press.
The Complex Self
Arrows criticisms of Titmuss’s arguments are right some of the time. Markets in blood may decrease altruism as a motive for giving blood but altruism must be distinguished from giving, sharing and co-operating. His argument is some commitment beyond a system of self-seeking individuals is necessary. (Arrow in Swedberg, 1990 p137)
The major finding of Titmuss was that the quantity of blood supplied was higher in countries such as the UK where no money was offered to those who gave blood but in percentage terms only 6% of eligible donors give blood in the UK. There is not comparable figures for the US. (Arrow, 1972 p350). Arrow makes the important point the data does not support Titmuss’s assertion a market in blood decreases altruism. The question as to why the development of a market in blood would decrease altruism is not addressed by Titmuss. (Arrow, 1972 p351). Titmuss suggests private market systems deprive men of their freedom to choose to give or not to give. It is a moral and political decision for the society as a whole he says. Arrow can find no support for such a dilemma. It may be the failure of voluntary giving to supply blood led to the commercial practice. (Arrow, 1972 p350). The poor and unemployed are predominately the suppliers of blood in the US and he wonders why anybody would object to them improving their financial situation.(Arrow, 1972 p347-351)
Arrow recognizes the allocation of goods and services is not accomplished entirely by exchange. The donation of blood is only one example of a large class of transactions for which there is not an element of payment. The whole structure of government expenditure is a departure from the system of mutual exchange. (Arrow, 1972 p344) In China and France for example, it is the government that manages the process of organizing the supply of blood. This has not improved the quality or the quantity of blood. In the last decades there have been a number of examples of systematic failures to maintain quality and a series of cover-ups and avoidance of responsibility for the transmission of infectious diseases. Arrow makes the point the process of exchange requires the presence of truth and trust in future dealings (Arrow, 1972 p344). A world of giving may improve efficiency because the price system does not always work. Experience has shown there are externalities in the supply of blood. These benefits and costs are transmitted among individuals for whom compensation in price terms is not and perhaps cannot be obtained. There is the example of hepatitis infection rates from commercial blood (Arrow, 1972 p351). In this respect truthfulness could contribute to the efficiency of the system because a voluntary system reinforces truthfulness (Arrow, 1972 p353). Some alternative system of determining quality and providing assurance for buyers is needed. One such would be a sense of social responsibility on the part of the seller.
Ethical behavior can be regarded as a socially desirable institution which facilitates the achievement of economic efficiency (Arrow, 1972 p354).
Ethical behavior should be confined to circumstances where the price system breaks down. It may not be wise to use the scarce resources of altruistic motivation. Ethically motivated behavior may even have a negative value to others if the agents act without sufficient knowledge of the situation. It may be argued that ethical codes serve as an instrument for increasing the economic advantage of one segment of the population at the expense of the rest (Arrow, 1972 p355). Arrow believes in the great importance of truthfulness in widely prevalent circumstances of economic life. Every commercial transaction has an element of trust, certainly any transaction conducted over a period of time. (Arrow, 1972 p356). Where price or quality is unknown, taking advantage is a classic case of exploitation. The price system must involve property rights. To the extant it is incomplete it must be supplemented by an implicit or explicit social contract. The categorical imperative and the price system are essential complements (Arrow, 1972 p357). An appeal against the market has a way of slipping into a defense of privilege (Arrow, 1972 p359). Titmuss wants to express a diffuse expression of confidence by individuals in the workings of a society as a whole. (Arrow, 1972 p360).
Arrow identifies three motives for giving blood; a generalized desire to benefit others, a feeling of social obligation and donations to known recipients. (Arrow, 1972 p348). In utility theory the welfare of the individual will depend on his satisfaction and on the satisfaction obtained by others. Varoufakis agrees this is part selfishness and part selflessness. (1998 p299-300) He says we enjoy the way we look in other people’s eyes. It is a creative act that loses its value if payment is received. The comfort of being useful as Scitovsky puts it. (1976 p120-121) He gives not in the hope of reciprocity but a strengthening of ties. He notes that beyond the circle of close friends and family giving can be seen as status seeking or buying acceptance. In Arrow’s utility theory the welfare of the individual will depend both on his satisfaction and on the satisfactions obtained by others. The welfare of each individual depends not only on the utilities of himself and others but also on his contributions to the utilities of others. Each individual is in some ultimate sense, motivated by purely egoistic satisfaction derived from the goods accruing to him, but there is an implicit social contract such that each performs duties for the other in a way calculated to enhance the satisfaction of all. (Arrow, 1972 p348)
Value introjections into economic action is socially oriented and guided by moral considerations. This is the acting out of collectively held values and may influence the character of personal goals and the selection of the means to accomplish them. (Portes, 1995 p4-5) The pursuit of material gain, when it interacts with other self-centered goals such as the quest for approval, status and power which depend on the opinion of others, commonly meets with the disapproval of others in the same social milieu. (Portes, 1995 p4-5) The unrestricted pursuit of gain is also constrained by reciprocity expectations built up in the course of social interaction. This web of expectations does not guarantee reciprocity but it insures the actors will go to some lengths to conceal the actions that carry the threat of sanctions. (Portes, 1995 p4-5) Monroe sees perspective as the difference between altruistic actions and giving. Altruists have a feeling of such strong links to humanity it leaves them no choice in their behavior when others are in great need. (Monroe, 1996 233-238) For her there is no element of self interest. Fogelman (1999) noticed in her interviews of 600 people who had helped Jews escape the Holocaust a majority had not come from secure childhoods of loving security. Instead they had been rescued by a guardian like figure at some point. She conjectures this as a significant indicator for future altruistic acts. It could be argued the failure of administrators to adequately monitor the quality of blood in a number of countries in the last decades implies the web of expectations about the quality of blood only inspired the concealment of irresponsibility. Perhaps the lack of leadership, frequently volunteers acting as trustees, from the top of these organizations contributed to the both the cover up and the extraordinary amount of time it has taken to get compensation for the victims of the tainted blood.
References
Arrow, Kenneth (1972) “Gifts and Exchanges,” Philosophy and Public Affairs, 1(4): 343-362.
Fogelman, E, (1999) Website accessed 23 June 2004 http://www.english.upenn.edu/~afilreis/Holocaust/rescuers-article.html
Portes, A (1995) ‘Economic Sociology of Immigration: A Conceptual Overview’ in The Economic Sociology of Immigration. Russel Sage Foundation. New York.
Scitovsky, Tibor (1976) The Joyless Economy, Oxford: Oxford University Press.
Swedberg, Richard (1990) Economics and Sociology: Redefining their Boundaries: Conversations with Economists and Sociologists, Princeton, N.J.: Princeton University Press.
Titmuss, Richard M. (1970) The Gift Relationship: From Human Blood to Social Policy, London: George Allen & Unwin Ltd. Chapters 1, 12, 13, 14.
Varoufakis, Y. (1998) Foundations of Economics: A beginner’s companion, London: Routledge.
The major finding of Titmuss was that the quantity of blood supplied was higher in countries such as the UK where no money was offered to those who gave blood but in percentage terms only 6% of eligible donors give blood in the UK. There is not comparable figures for the US. (Arrow, 1972 p350). Arrow makes the important point the data does not support Titmuss’s assertion a market in blood decreases altruism. The question as to why the development of a market in blood would decrease altruism is not addressed by Titmuss. (Arrow, 1972 p351). Titmuss suggests private market systems deprive men of their freedom to choose to give or not to give. It is a moral and political decision for the society as a whole he says. Arrow can find no support for such a dilemma. It may be the failure of voluntary giving to supply blood led to the commercial practice. (Arrow, 1972 p350). The poor and unemployed are predominately the suppliers of blood in the US and he wonders why anybody would object to them improving their financial situation.(Arrow, 1972 p347-351)
Arrow recognizes the allocation of goods and services is not accomplished entirely by exchange. The donation of blood is only one example of a large class of transactions for which there is not an element of payment. The whole structure of government expenditure is a departure from the system of mutual exchange. (Arrow, 1972 p344) In China and France for example, it is the government that manages the process of organizing the supply of blood. This has not improved the quality or the quantity of blood. In the last decades there have been a number of examples of systematic failures to maintain quality and a series of cover-ups and avoidance of responsibility for the transmission of infectious diseases. Arrow makes the point the process of exchange requires the presence of truth and trust in future dealings (Arrow, 1972 p344). A world of giving may improve efficiency because the price system does not always work. Experience has shown there are externalities in the supply of blood. These benefits and costs are transmitted among individuals for whom compensation in price terms is not and perhaps cannot be obtained. There is the example of hepatitis infection rates from commercial blood (Arrow, 1972 p351). In this respect truthfulness could contribute to the efficiency of the system because a voluntary system reinforces truthfulness (Arrow, 1972 p353). Some alternative system of determining quality and providing assurance for buyers is needed. One such would be a sense of social responsibility on the part of the seller.
Ethical behavior can be regarded as a socially desirable institution which facilitates the achievement of economic efficiency (Arrow, 1972 p354).
Ethical behavior should be confined to circumstances where the price system breaks down. It may not be wise to use the scarce resources of altruistic motivation. Ethically motivated behavior may even have a negative value to others if the agents act without sufficient knowledge of the situation. It may be argued that ethical codes serve as an instrument for increasing the economic advantage of one segment of the population at the expense of the rest (Arrow, 1972 p355). Arrow believes in the great importance of truthfulness in widely prevalent circumstances of economic life. Every commercial transaction has an element of trust, certainly any transaction conducted over a period of time. (Arrow, 1972 p356). Where price or quality is unknown, taking advantage is a classic case of exploitation. The price system must involve property rights. To the extant it is incomplete it must be supplemented by an implicit or explicit social contract. The categorical imperative and the price system are essential complements (Arrow, 1972 p357). An appeal against the market has a way of slipping into a defense of privilege (Arrow, 1972 p359). Titmuss wants to express a diffuse expression of confidence by individuals in the workings of a society as a whole. (Arrow, 1972 p360).
Arrow identifies three motives for giving blood; a generalized desire to benefit others, a feeling of social obligation and donations to known recipients. (Arrow, 1972 p348). In utility theory the welfare of the individual will depend on his satisfaction and on the satisfaction obtained by others. Varoufakis agrees this is part selfishness and part selflessness. (1998 p299-300) He says we enjoy the way we look in other people’s eyes. It is a creative act that loses its value if payment is received. The comfort of being useful as Scitovsky puts it. (1976 p120-121) He gives not in the hope of reciprocity but a strengthening of ties. He notes that beyond the circle of close friends and family giving can be seen as status seeking or buying acceptance. In Arrow’s utility theory the welfare of the individual will depend both on his satisfaction and on the satisfactions obtained by others. The welfare of each individual depends not only on the utilities of himself and others but also on his contributions to the utilities of others. Each individual is in some ultimate sense, motivated by purely egoistic satisfaction derived from the goods accruing to him, but there is an implicit social contract such that each performs duties for the other in a way calculated to enhance the satisfaction of all. (Arrow, 1972 p348)
Value introjections into economic action is socially oriented and guided by moral considerations. This is the acting out of collectively held values and may influence the character of personal goals and the selection of the means to accomplish them. (Portes, 1995 p4-5) The pursuit of material gain, when it interacts with other self-centered goals such as the quest for approval, status and power which depend on the opinion of others, commonly meets with the disapproval of others in the same social milieu. (Portes, 1995 p4-5) The unrestricted pursuit of gain is also constrained by reciprocity expectations built up in the course of social interaction. This web of expectations does not guarantee reciprocity but it insures the actors will go to some lengths to conceal the actions that carry the threat of sanctions. (Portes, 1995 p4-5) Monroe sees perspective as the difference between altruistic actions and giving. Altruists have a feeling of such strong links to humanity it leaves them no choice in their behavior when others are in great need. (Monroe, 1996 233-238) For her there is no element of self interest. Fogelman (1999) noticed in her interviews of 600 people who had helped Jews escape the Holocaust a majority had not come from secure childhoods of loving security. Instead they had been rescued by a guardian like figure at some point. She conjectures this as a significant indicator for future altruistic acts. It could be argued the failure of administrators to adequately monitor the quality of blood in a number of countries in the last decades implies the web of expectations about the quality of blood only inspired the concealment of irresponsibility. Perhaps the lack of leadership, frequently volunteers acting as trustees, from the top of these organizations contributed to the both the cover up and the extraordinary amount of time it has taken to get compensation for the victims of the tainted blood.
References
Arrow, Kenneth (1972) “Gifts and Exchanges,” Philosophy and Public Affairs, 1(4): 343-362.
Fogelman, E, (1999) Website accessed 23 June 2004 http://www.english.upenn.edu/~afilreis/Holocaust/rescuers-article.html
Portes, A (1995) ‘Economic Sociology of Immigration: A Conceptual Overview’ in The Economic Sociology of Immigration. Russel Sage Foundation. New York.
Scitovsky, Tibor (1976) The Joyless Economy, Oxford: Oxford University Press.
Swedberg, Richard (1990) Economics and Sociology: Redefining their Boundaries: Conversations with Economists and Sociologists, Princeton, N.J.: Princeton University Press.
Titmuss, Richard M. (1970) The Gift Relationship: From Human Blood to Social Policy, London: George Allen & Unwin Ltd. Chapters 1, 12, 13, 14.
Varoufakis, Y. (1998) Foundations of Economics: A beginner’s companion, London: Routledge.
Care for particular others
There are some similarities but more differences in the accounts Radford and Levi give about the development and operation of markets in prison camps.
Auschwitz was a firm specializing in labor hire. The prisoners were hired to factories specifically sited in the area; IG Farben made Buna, a form of synthetic rubber, at Birkenau two kilometers from Auschwitz. (Frydman) There was also an aircraft factory and other industries at Birkenau. The earliest prisoners were put to building an entire town there. The SS was paid 2 marks per prisoner per day by these companies. (Frydman) The selections were on the basis that if the prisoners were too sick or weak to produce labour value higher than 2 marks they went to the gas chambers. The old, infirm and children went straight from the transports. (Frydman) Another business conducted was the recycling of the prisoners personal belongings. This was the stock that was exchanged across the wire for food. The work parties had ample opportunity to exchange these goods in the factories and town to which they were sent daily. (Frydman) In contrast the prisoners in Radford’s camp were not forced into labour although they did engage in trade outside the camp itself and between different sections of the camp.
The concentration camp social structure Levi survived was very different from that described by Radford. The Jews were at the bottom and treated the harshest. There were also other groups including German political prisoners, convicted criminals from Germany and Poland, Gypsies, Russian prisoners of war, homosexuals, prostitutes and others deemed anti-social by the SS. The hut blockalteste and kapo enjoyed privileged status, better food and the ability to inflict beatings or death on those they controlled. (Cohen, 2001) The hierarchy was imposed on the prisoners by the Germans. One of the basic Nazi aims was to demoralize, humiliate, ruin their prisoner, not only physically but also spiritually. Their spies were constantly among the prisoners to keep them informed about every thought, every feeling, and every reaction they had. There was only one law in Auschwitz - the law of the jungle. (Gisella, 1984) The situation in Radford’s camps was totally different. The men were already part of a cohesive structure with shared norms that Radford describes as more sociological than market based. (Radford p81) In Radford’s camp a hierarchy was already in place in the form of the ranks the captives held prior to captivity. All the men in Radford’s camp knew they were being monitored by the Red Cross and that they had a high probability of being released eventually. Levi’s cohort knew their lives could be terminated randomly. I suggest the differences are profound enough to affect the way the exchanges took place.
(Rosenbaum, 2000) offers a definition of a market that includes a voluntary and specified exchange, typification, regularity and competition. Some of these features existed in Radford’s camp, less in Levis. For example specified exchange was common in Radford’s in that the unit of exchange was cigarettes. Food was bought and sold with them. In Levi’s camp the exchange was direct, food for any item considered desirable. The ability to survive depended on the agents luck in finding or stealing these items. Both Levi and Radford describe a labor market that developed in the camps. It was possible to arrange for a number of services to be performed in return for a suitable exchange. Polanyi describes an exchange as a form of integration where the distribution of goods takes place via price-making markets. (1957, 1971 in Swedberg, 2003 p28) In Radford’s camp the price was in cigarettes. In Levi’s camp a barter system was used. A labor theory of value implies only value from labor has merit. In Levi’s Auschwitz this took on special meaning. Only those fit enough to work survived a daily selection that ended in the gas chamber for those not of value. (Cohen,2001.) It required a great deal of time to accumulate the capital to begin a trading stock because the decision had to be made on how much to consume and how much to save. In Radford’s case the Red Cross replenished the trading stock on a regular basis. The bribery necessary to find work in the laundry rather than building roads meant the difference between life and death. A great deal of time was spent in making contacts in other work groups to facilitate exchange of goods and positions. (Cohen, 2001
The different accounts of Levi and Radford give rise to interesting questions on the implications for how we think about the relationship between markets and other social institutions. In the neo-classic account of markets there are three necessary conditions for Pareto optimality: There are large numbers of buyers and sellers so no one has the ability to manipulate the market. There is no inter-dependence between individuals other than through their all being participants in the market and there exists complete information available to all relevant parties. (Seabright, 2004 p99) The Levi and Radford stories show how non-optimal prison camp exchanges were. A more sociological view of actions in markets seems necessary, with a conceptual view of the social institutions that comprise markets. (Fligstein, 1996) According to Fligstein markets can be characterized as social situations in which goods are exchanged for a monetary price and these situations can come into being only if the following three elements are present: property rights, governance structures and rules of exchange. Property rights are defined as social relations that determine who is entitled to the profit from an exchange. Governance structures consist of rules for how to organize an exchange as well as competition and co-operation. And rules of exchange determine under what conditions exchange can take place and who can take part. Fligstein also emphasized the role of conflict and struggle in the market. (Swedberg, 2003 p118-130). Bordieu starts from the idea that economic life is largely the result of the encounter between actors with special dispositions in the economic field. It is dominated by its dynamics. Prices are determined by the structure of the field and not the other way round. This is similar to Fligstein’s idea of organizational fields in which actors orient themselves to each other. They agree the notion of networks to analyze markets is unsatisfactory since it focuses exclusively on social interactions. (Swedberg, 2003 p118-130). For Granovetter networks of personal relations are where transactions must take place. He suggests it is a commonplace that buying and selling relationships rarely approximate the spot market model of classical theory. (Granovetter, 1995 p225) In both camps networks of personal relations were a crucial aspect of exchange. Granovetter has also used the embeddedness approach to explain the stickiness of prices. Two crucial aspects of markets little explored by economic sociologists are how prices are set and the role of law. Weber said money processes are the product of conflicts of interest and of compromise and are thus the result of power constellations. (Swedberg, 2003p118-130) This was certainly the case in both camps.
References
Cohen, J. ( 2001.) Website accessed June 23, 2004 http://www3.sympatico.ca/mighty1/mothers/sky1.htm
Fligstein, Neil (1996) “Markets as Politics: A Political Cultural Approach to Market Institutions,” American Sociological Review, 61(4): 656-673.
Frydman, A Website accessed 24 June 2004 http://www.purs.org/survivors/alive_winter.htm
Granovetter, Mark (1974 or 1995) Getting a job: a study of contacts and careers. Chicago: Chicago University Press.
Levi, P (2000 [1958]) If this is a man, London: Abacus. Chapter 8, “This side of good and evil.”
Perl G, (1984) Website accessed 23 June 2004 http://www.spartacus.schoolnet.co.uk/GERauschwitz.htm
Pitelis, Christos (ed) (1993) Transaction Costs, Markets and Hierarchies, London: Blackwell.
Radford, R. A. (1945/1996) “The Economic Organisation of a POW Camp” Excerpted in Frank Stilwell and George Argyrous (eds) Economics as a Social Science, Sydney: Pluto Press.
Rosenbaum, Eckehard F. (2000) “What is a Market? On the Methodology of a Contested Concept” Review of Social Economy 58(4): 455– 482.
Seabright, Paul. (2004)The company of strangers : a natural history of economic life
Princeton, N.J. : Princeton University Press,
Swedberg, Richard. (2003) Principles of economic sociology
Princeton, N.J. : Woodstock : Princeton University Press
Zelizer, Viviana (1996) “Payments and Social Ties,” Sociological Forum, 11(3): 481-495.
Auschwitz was a firm specializing in labor hire. The prisoners were hired to factories specifically sited in the area; IG Farben made Buna, a form of synthetic rubber, at Birkenau two kilometers from Auschwitz. (Frydman) There was also an aircraft factory and other industries at Birkenau. The earliest prisoners were put to building an entire town there. The SS was paid 2 marks per prisoner per day by these companies. (Frydman) The selections were on the basis that if the prisoners were too sick or weak to produce labour value higher than 2 marks they went to the gas chambers. The old, infirm and children went straight from the transports. (Frydman) Another business conducted was the recycling of the prisoners personal belongings. This was the stock that was exchanged across the wire for food. The work parties had ample opportunity to exchange these goods in the factories and town to which they were sent daily. (Frydman) In contrast the prisoners in Radford’s camp were not forced into labour although they did engage in trade outside the camp itself and between different sections of the camp.
The concentration camp social structure Levi survived was very different from that described by Radford. The Jews were at the bottom and treated the harshest. There were also other groups including German political prisoners, convicted criminals from Germany and Poland, Gypsies, Russian prisoners of war, homosexuals, prostitutes and others deemed anti-social by the SS. The hut blockalteste and kapo enjoyed privileged status, better food and the ability to inflict beatings or death on those they controlled. (Cohen, 2001) The hierarchy was imposed on the prisoners by the Germans. One of the basic Nazi aims was to demoralize, humiliate, ruin their prisoner, not only physically but also spiritually. Their spies were constantly among the prisoners to keep them informed about every thought, every feeling, and every reaction they had. There was only one law in Auschwitz - the law of the jungle. (Gisella, 1984) The situation in Radford’s camps was totally different. The men were already part of a cohesive structure with shared norms that Radford describes as more sociological than market based. (Radford p81) In Radford’s camp a hierarchy was already in place in the form of the ranks the captives held prior to captivity. All the men in Radford’s camp knew they were being monitored by the Red Cross and that they had a high probability of being released eventually. Levi’s cohort knew their lives could be terminated randomly. I suggest the differences are profound enough to affect the way the exchanges took place.
(Rosenbaum, 2000) offers a definition of a market that includes a voluntary and specified exchange, typification, regularity and competition. Some of these features existed in Radford’s camp, less in Levis. For example specified exchange was common in Radford’s in that the unit of exchange was cigarettes. Food was bought and sold with them. In Levi’s camp the exchange was direct, food for any item considered desirable. The ability to survive depended on the agents luck in finding or stealing these items. Both Levi and Radford describe a labor market that developed in the camps. It was possible to arrange for a number of services to be performed in return for a suitable exchange. Polanyi describes an exchange as a form of integration where the distribution of goods takes place via price-making markets. (1957, 1971 in Swedberg, 2003 p28) In Radford’s camp the price was in cigarettes. In Levi’s camp a barter system was used. A labor theory of value implies only value from labor has merit. In Levi’s Auschwitz this took on special meaning. Only those fit enough to work survived a daily selection that ended in the gas chamber for those not of value. (Cohen,2001.) It required a great deal of time to accumulate the capital to begin a trading stock because the decision had to be made on how much to consume and how much to save. In Radford’s case the Red Cross replenished the trading stock on a regular basis. The bribery necessary to find work in the laundry rather than building roads meant the difference between life and death. A great deal of time was spent in making contacts in other work groups to facilitate exchange of goods and positions. (Cohen, 2001
The different accounts of Levi and Radford give rise to interesting questions on the implications for how we think about the relationship between markets and other social institutions. In the neo-classic account of markets there are three necessary conditions for Pareto optimality: There are large numbers of buyers and sellers so no one has the ability to manipulate the market. There is no inter-dependence between individuals other than through their all being participants in the market and there exists complete information available to all relevant parties. (Seabright, 2004 p99) The Levi and Radford stories show how non-optimal prison camp exchanges were. A more sociological view of actions in markets seems necessary, with a conceptual view of the social institutions that comprise markets. (Fligstein, 1996) According to Fligstein markets can be characterized as social situations in which goods are exchanged for a monetary price and these situations can come into being only if the following three elements are present: property rights, governance structures and rules of exchange. Property rights are defined as social relations that determine who is entitled to the profit from an exchange. Governance structures consist of rules for how to organize an exchange as well as competition and co-operation. And rules of exchange determine under what conditions exchange can take place and who can take part. Fligstein also emphasized the role of conflict and struggle in the market. (Swedberg, 2003 p118-130). Bordieu starts from the idea that economic life is largely the result of the encounter between actors with special dispositions in the economic field. It is dominated by its dynamics. Prices are determined by the structure of the field and not the other way round. This is similar to Fligstein’s idea of organizational fields in which actors orient themselves to each other. They agree the notion of networks to analyze markets is unsatisfactory since it focuses exclusively on social interactions. (Swedberg, 2003 p118-130). For Granovetter networks of personal relations are where transactions must take place. He suggests it is a commonplace that buying and selling relationships rarely approximate the spot market model of classical theory. (Granovetter, 1995 p225) In both camps networks of personal relations were a crucial aspect of exchange. Granovetter has also used the embeddedness approach to explain the stickiness of prices. Two crucial aspects of markets little explored by economic sociologists are how prices are set and the role of law. Weber said money processes are the product of conflicts of interest and of compromise and are thus the result of power constellations. (Swedberg, 2003p118-130) This was certainly the case in both camps.
References
Cohen, J. ( 2001.) Website accessed June 23, 2004 http://www3.sympatico.ca/mighty1/mothers/sky1.htm
Fligstein, Neil (1996) “Markets as Politics: A Political Cultural Approach to Market Institutions,” American Sociological Review, 61(4): 656-673.
Frydman, A Website accessed 24 June 2004 http://www.purs.org/survivors/alive_winter.htm
Granovetter, Mark (1974 or 1995) Getting a job: a study of contacts and careers. Chicago: Chicago University Press.
Levi, P (2000 [1958]) If this is a man, London: Abacus. Chapter 8, “This side of good and evil.”
Perl G, (1984) Website accessed 23 June 2004 http://www.spartacus.schoolnet.co.uk/GERauschwitz.htm
Pitelis, Christos (ed) (1993) Transaction Costs, Markets and Hierarchies, London: Blackwell.
Radford, R. A. (1945/1996) “The Economic Organisation of a POW Camp” Excerpted in Frank Stilwell and George Argyrous (eds) Economics as a Social Science, Sydney: Pluto Press.
Rosenbaum, Eckehard F. (2000) “What is a Market? On the Methodology of a Contested Concept” Review of Social Economy 58(4): 455– 482.
Seabright, Paul. (2004)The company of strangers : a natural history of economic life
Princeton, N.J. : Princeton University Press,
Swedberg, Richard. (2003) Principles of economic sociology
Princeton, N.J. : Woodstock : Princeton University Press
Zelizer, Viviana (1996) “Payments and Social Ties,” Sociological Forum, 11(3): 481-495.
Trusting Risk
"How does trust affect the operational risk of agents in financial markets?"
Financial markets typically postulate the orthodox economics of a rational choice theory and optimal individual maximization as most efficient. In this paper I suggest trust provides a wider and deeper motivation for economic action. Operational risk is a subset of the total risks facing economic agents in financial markets. I examine the interaction of trust and operational risk in a number of contexts and arrive at the suggestion trust can affect operational risk in a way not wholly explainable by theories of pure rational choice or individual maximization alone.
The thesis that risk assessment itself is inherently risky is nowhere better borne out than in the area of high-consequence risks. (Giddens, 1991 p122) In an era of global financial markets operating continuously, dealing in monetary amounts orders of magnitude bigger than a decade ago and between loosely bonded agents the probability of contagion from institutional failure is growing. The theoretical interest in risk management is driven by the need to ameliorate just such a crisis. Three major risks face agents in financial markets are market risk, credit risk and operational risk. The Basel Committee on Banking Supervision of the Bank for International Settlements defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems. (DM Review, 2003). Important types of operational risks include fraud and mismanagement such as dealers, lending officers and other staff exceeding their authority or conducting business in an unscrupulous or perilous manner. (DM Review, 2003).
Operational risk within the banking industry is an area of operational risk where the potential losses are high and the actual losses can be difficult to measure. (Walker, 2001 p252) Examples include rogue trading where the potential losses can be extremely high and may not be discovered until it is too late to do anything about them and the situation where the large number of discretionary fees applied to clients allow significant scope for fraud. (Walker, 2001 p253) Banks conduct large numbers of foreign exchange transactions 95% of which are speculative. In this environment, the human factor plays a major role. Banks represent the major proponents of individual maximization and rational choice theory. They are the most in favour of free markets as the most efficient allocaturs of risk and return. They are also the bastion of the econometric approach to managing risk. Basel II is the Accord on capital adequacy due to be introduced by BIS through the BCBS from the end of 2006. This Accord recommends the setting aside of a fixed proportion of capital to cover the cost of operational risk. Are there cheaper alternatives? I will explore some definitions and applications of trust in various contexts and seek to apply these notions to operational risk.
Trust can be described as a particular level of subjective probability with which an agent can assess that another agent will perform a particular action (Gambetta, 1988 in Misztal, 1996 p82). This assumes agents are likely to behave rationally and that trust provides the best strategy for behaving co-operatively. (Misztal, 1996 p85). There is a strong emphasis placed on the incremental nature of the building of trust. (Misztal, 1996 p85). This process needs time and the experience of numerous transactions (Misztal, 1996 p84) This definition accepts trust as a synonym with rational expectations (Ostrom, 1990 in Misztal, 1996 p85) but then goes on to view people as fallible and norm-adapting, and pursuing contingent strategies in complex and uncertain environments. (Ostrom, 1990 in Misztal, 1996 p85) This view expects individuals to make a commitment to rules which describe their mutual rights and obligations which are developed internally in the process of interactions. (Ostrom, 1990 in Misztal, 1996 p85) Trust relationships then monitor and sanction such rules and obligations. This could explain the relationships between the semi-autonomous specialists found on the floor of the NYSE. (Abolafia, 1996 Ch 5). But would not address the informational asymmetries exploited by the hyper-rational bond traders screen trading for large institutions. (Abolafia, 1996 Ch 1).
A distinction needs to be made between the information available to traders within an institution and between institutions. Traders use the institutions sales force, economists and technology to form views on the fundamental value of the bonds they trade. This information is constantly updated and forms the base from which the traders build positions in the market. A certain amount of trust in the judgement and efficiency of the providers of this information is necessary. On the other hand institutional customers are frequently offered incomplete information and their ignorance is often taken advantage of. (Abolafia, 1996 p20). This leads to a culture of mistrust. The customers, such as mutual funds and insurance companies, frequently need to seek information from four or five firms before transacting. (Abolafia, 1996 p20). Furthermore traders not only conceal information, they frequently distort it. (Abolafia, 1996 p20). Showing bids, using the semi-anonymity of screen based trading, to post a higher bid then withdrawing it, the trader hopes others will buy from a third and then attempt to sell in a quick exchange. This sometimes means selling at a loss. (Abolafia, 1996 p21). This is certainly a breach of trust but not illegal. Front running and trading insider information are illegal. Buying a parcel of bonds, marking them up in price and then reselling them to a customer on the certain fore-knowledge the customer is about to purchase is front running. Using information about the economic condition or intentions of a bond issuer not available to the rest of the market is insider trading (Abolafia, 1996 p21). Both are common in financial markets because of the difficulty of detection and add to the culture of distrust.
To what extant is distrust bred by the mere effort to regulate and is there an irresolvable conflict between regulation and trust? (Cvetkovich & Lofstedt, 1999 p166) The argument implies the less regulation the more likely trusting relationships will be built. Some anecdotal evidence suggests the socialization of traders to the unwritten scripts of trustworthy behaviour in bond markets broke down during the period of deregulation in the 1980’s. (Abolafia, 1996 p21). Every time an example of fraud comes to light institutions and regulators seek to institute new systems to guard against the possibility of re-occurrence. This has resulted in a struggle between the proponents of ‘free’ markets who insist institutions should be allowed to fail and those who see the interconnectedness of these institutions and the consequent risk of contagion too high to be left unregulated. In practice there has developed a dual approach. Some institutions are allowed to go under (Barings after Nick Leeson) and Long Term Capital Management which was re-capitalized. The difference appears to revolve around not just the size of the institution but the way the losses were incurred. If the cause was mismanagement or ‘bad luck’ rather than fraud the institutions are thrown a lifeline.
The Nick Leeson and Barings story is a classic tale of operational risk and the breakdown of trust. After some experience of back office management Leeson was allowed to manage the back office and undertake trading in derivatives in the Singapore office of Barings Bank. From the first he set up and ran a false account to hide his losses and other accounts to declare his gains to head office in London. (Risk Glossary.com 2004). At his trial he defended himself by stating his superiors knew what he was doing. They trusted him on the basis of his previous good conduct. An example of the incremental building of trust discussed above. Almost from his first trade he lost money. (Risk Glossary.com 2004). In a classic example of prospect theory (Tversky and Kahneman, 1981) he began to chase his losses. He doubled his bets in a Martingale until he held half the open interest in the Nikkei 200 futures contract and 85% of the open interest in the Japanese Government Bond futures contracts – a total of GBP 827 million. (Risk Glossary.com 2004). Of course other traders knew somebody was out there accumulating these positions. Derivatives are a zero sum game and all the money he lost was transferred to others. Subsequently every institution trading derivatives made the activities of the back office operationally separate from the traders which introduced a level of intra firm regulation that did not allow for the sort of trust that had cost Barings its economic life. I would argue this example suggests there is an irresolvable conflict between the urge to regulate and trust. I would also suggest the irrationality of Leesons’ trades indicated to risk managers and other traders he had ceased to be committed to the rules of his institution which described their mutual rights and obligations and instead was pursuing a contingent strategy at odds with the rational expectations of his employers.
Social ties, notably kith, kin and co-ethnics, increase trust and trustworthiness, and thus mitigate breach of agreement. (Salter 2002 p279) Landa (1994 p101) suggests this is particularly true in traditional markets as a way of coping with contract uncertainty. She expects the exchange networks based on mutual trust to be replaced by impersonal exchange networks based on contract as an economy develops legal infrastructure. Landa (1994 p113). This implies family firms are limited in scale and lack complexity. This generalization is challenged by Wong who found in many settings large business groups are controlled by one or two families. (Wong, 1985 in Smelser and Swedberg, 1994 p463) Whatever the size of institutions, certain results from the usage of trust are common to all, including the reduction of transaction costs. I include the reduction of the hedging premium or insurance cost associated with operational risk in this definition of transaction costs.
The lower transaction costs associated with searches within ethnic boundaries has two characteristics. Members of the same ethnic community are perceived to be more trustworthy (Landa, 1994 p111). Second it is easier to acquire more information from the network of mutual aid associations within the same community. (Landa, 1994 p111). This trust can be characterised as transitive trust because to trust one business partner is to trust her business partner. (Landa, 1994 p111). This builds an expanding network of initially strong but then progressively weaker ties all bound together by trust. (Granovetter, 1974). If Landa is right and impersonal exchange networks based on contract replace ethnic networks based on trust, then these agents should look forward to an increase in transaction costs, including operational risk, without any increase in efficiency.
Until then, ethnic networks based on trust provide a good example of the definitions outlined above. These individuals make a commitment to rules which describe their mutual rights and obligations which are developed internally in the process of incremental interactions. The relationships are then monitored and sanctioned. In the complex and uncertain environments of minorities doing business within larger economic systems these rational agents build deeper and wider behaviours that mitigate operational risks and the costs involved.
McKean conjectures it would be extremely expensive to contractualize every aspect of an agreement. (McKean, 1975 p31). In fact the financial markets should not be included in this generalization. The over-the-counter market for financial instruments is much larger than the exchange traded markets with notional values of derivatives alone being US$128 trillion at the end of 2002. (Beyer, 2003) In these markets the International Swaps and Derivatives Association has developed and distributes to its members a standardised contract. Trades are executed over the phone with the voice recording being the evidence of the offer and acceptance of the contract. Consideration passes at the settlement which is typically by 10 am the following day. Exchange traded markets use a clearing house which forms a novated contract between the parties. There has not been a clearing house fail in the more than 100 years of futures and options trading (Beyer, 2003). These contractual systems are relatively simple, historically robust and have relatively low transaction costs. In the financial markets the transaction cost savings are more to be found within the institution than between institutions.
The Leeson story is an example. According to Hechter (in Misztal, 1996 p86) what is necessary for cooperation in large groups is formal control. However Molm, Takahashi and Peterson (2000 p1398) suggest negotiated terms and strictly binding agreements have the unintended consequence of reducing trust in relationships. For them the risk of incurring a net loss provides the opportunity for exchange partners to demonstrate their trustworthiness. (Molm, Takahashi and Peterson, 2000 p1401) Raise the level of uncertainty and the partners level of trust will increase in a reciprocal exchange. This difference is attributed to the expectation of future interaction. (Molm, Takahashi and Peterson, 2000 p1404) So inside an institution the development of reciprocal exchange should increase trust. By this logic if Leeson had not been a one man band, Barings would still be alive today. But how did the sales force in the Abolafia study feel about the bond traders who systematically communicated incomplete and misleading information? (Abolafia, 1996 p20) I would suggest they would grow increasingly distrustful no matter how many reciprocal exchanges were expected. The traders would have to develop some other form of opportunity to compensate the sales-force for this loss of utility. And here opens the potential for an increase in operational risk. The temptation to engage in collusive fraud, should the opportunity arise, would increase. This leads us back to the need for the introduction of formal controls.
Formal controls have been increasingly implemented in institutions. Chinese walls have been built between analysts and traders to mitigate conflicts of interest. Risk managers have more econometric tools to measure and manage risk. The psychometric testing of traders has increased. These institutions demand their employees make a commitment to rules which describe their mutual rights and obligations but which are enshrined in contracts. This assumes agents are likely to behave rationally and that trust provides the best strategy for behaving co-operatively. But if they behave irrationally, in situations where trust has broken down, then these institutions have a hedge. The cost of implementing these insurance policies is high. But the cost of not having them is higher.
Conclusion
In this paper I have explored theories of trust and asked how they affect operational risk. Without eliminating the use of rational choice theory or individual utility maximization it becomes clear utilizing notions of trust deepens and widens understanding of efficient market behaviour. Informational asymmetries within and between institutions were compared to illustrate the effects on trust and operational risk. Aspects of the debate over regulation and its affect on trust and operational risk were examined. I have argued trust plays an important role in reducing a number of costs associated with operational risk for the small ethnic entrepreneur in traditional markets and the largest and most complex institutions in financial markets, Drawing on stories from bond traders in the 1980’s and the failure of Barings in the 1990’s I have demonstrated how mistrust within institutions can grow and compared that with aspects of the development of trust based on expectations of reciprocity. Contractual arrangements within and between institutions were compared. Leading to the conclusion trust affects operational risk in a number of ways.
References
Abolafia, M. (1996) Making Markets: Opportunism and Restraint on Wall Street, Harvard UP, Cambridge Mass. Chapter 1, “Homo Economicus Unbound: Bond Traders on Wall Street”, and Chapter 5, “Homo Economicus Restrained: Identity and Control at the New York Stock Exchange”.
Baron, J. (1998) “Trust: beliefs and morality.” In A. Ben-Ner and L. Putterman (Eds) Economics, Values and Organization. Cambridge: Cambridge University Press.
Beyer, M. (2003) The Fourth Horseman. Canadian Securities Institute Website accessed may 15 2004 https://www.csi.ca/student/en_ca/infocus/demo/e-editorial.html
Cvetkovich, G & Lofstedt R (1999) Social trust and the Management of Risk Earthscan Publications UK.
DM Review (2003) Basel II: Measuring the Operational Risk
Website accessed May 21 2004
http://www.dmreview.com/article_sub.cfm?articleId=7550
Franklin, Jane (1998) The politics of risk society Malden, Mass. Polity
Press.
Friedland, Roger and A.F. Robertson (1990) Beyond the Marketplace: Rethinking Economy and Society, New York: Aldine de Gruyter
Füredi, Frank (2002). Culture of fear: risk-taking and the morality of low expectation London; New York: Continuum
Gambetta, D (1988) Trust: making and breaking cooperative relations. New York, NY, USA: B. Blackwell
Giddens, A (1991) Modernity and self-identity. Self and society in the late modern age. Cambridge (Polity Press), Website accessed 14 May 2004. http://www.ldb.org/giddens.htm
Glasberg, D and Skidmore D (1998) “The Dialectics of White-Collar Crime: The Anatomy of the Savings and Loans Crisis and the Case of Silverado Banking, savings and Loan Association,” American Journal of Economics and Sociology, 57(4):423-449
Granovetter, M. (1974) Getting a job: a study of contacts and careers. Chicago: Chicago University Press
Hechter M (1987) The Microfoundations of Macrosociology Philadelphia: Temple University Press
Hollis, M (1998) Trust within Reason, Cambridge: Cambridge University Press
Landa, J (1994) Trust, Ethnicity and Identity: Beyond the New Institutional Economics of Ethnic Trading Networks, Contract Law and Gift Exchange. Ann Arbor: University of Michigan Press. Chapter 5 “A theory of Ethnically Homogenous Middleman Group: An Institutional Alternative to Contract Law.”
Lewis, A and Mackenzie C. (2000) “Morals, money, ethical investing and economic psychology,” Human Relations, 53(2): 179-191
Luhmann, N. (1979) Trust Chichester. Wiley
Mansbridge, J. (1999) “Altruistic Trust,” in Mark Warren (Ed) Democracy and Trust, Cambridge: Cambridge University Press
McKean, R. (1975) “Economics of Trust, Altruism and Corporate Responsibility.” In Edmund Phelps (Ed) Altruism, morality and economic theory New York: Russell Sage Foundation
Misztal, Barbara A. (1996) Trust in modern societies: the search for the bases of social order Cambridge, Mass.: Polity Press
Misruchi, M and Stearns L. (1994) “Money, Banking and Financial Markets” in Neil Smelser and Richard Swedberg, (Eds) The Handbook of Economic Sociology. Princeton: Princeton University Press
Molm, L., Takahashi, N. and Peterson, G (2000) “Risk and Trust in social Exchange: An Experimental Test of a Classical Proposition,” American Journal of Sociology, 105(5): 1396-427
Ostrom, Elinor (1990). Governing the commons: the evolution of institutions for collective action. Cambridge: Cambridge University Press
Portes, A (1995a) Economic Sociology of Immigration: A Conceptual Overview in The Economic Sociology of Immigration. Russel Sage Foundation. New York.
Risk Glossary.com (2004) Website accessed may 25 2004
http://www.riskglossary.com/articles/barings_debacle.htm
Salter F.K. (2002) Risky Transactions: Trust, Kinship and Ethnicity Berghahn Books. New York
Smelser, N. and Swedberg, R. (Eds) (1994) The Handbook of Economic sociology. Princeton: Princeton University Press
Taylor-Gooby, P. (Ed) (2000) Risk, Trust and Welfare. Macmillan Press. London.
Tversky, Amos and Daniel Kahneman. (1981) “The framing of Decisions and the Psychology of Choice,” Science 21:453-458
Walker, S.M. (2001) Operational risk Management: Controlling opportunities and threats. Connley Walker: Victoria. Australia.
Williamson, Oliver. (1975) Markets and hierarchies. New York. The Free Press
Financial markets typically postulate the orthodox economics of a rational choice theory and optimal individual maximization as most efficient. In this paper I suggest trust provides a wider and deeper motivation for economic action. Operational risk is a subset of the total risks facing economic agents in financial markets. I examine the interaction of trust and operational risk in a number of contexts and arrive at the suggestion trust can affect operational risk in a way not wholly explainable by theories of pure rational choice or individual maximization alone.
The thesis that risk assessment itself is inherently risky is nowhere better borne out than in the area of high-consequence risks. (Giddens, 1991 p122) In an era of global financial markets operating continuously, dealing in monetary amounts orders of magnitude bigger than a decade ago and between loosely bonded agents the probability of contagion from institutional failure is growing. The theoretical interest in risk management is driven by the need to ameliorate just such a crisis. Three major risks face agents in financial markets are market risk, credit risk and operational risk. The Basel Committee on Banking Supervision of the Bank for International Settlements defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems. (DM Review, 2003). Important types of operational risks include fraud and mismanagement such as dealers, lending officers and other staff exceeding their authority or conducting business in an unscrupulous or perilous manner. (DM Review, 2003).
Operational risk within the banking industry is an area of operational risk where the potential losses are high and the actual losses can be difficult to measure. (Walker, 2001 p252) Examples include rogue trading where the potential losses can be extremely high and may not be discovered until it is too late to do anything about them and the situation where the large number of discretionary fees applied to clients allow significant scope for fraud. (Walker, 2001 p253) Banks conduct large numbers of foreign exchange transactions 95% of which are speculative. In this environment, the human factor plays a major role. Banks represent the major proponents of individual maximization and rational choice theory. They are the most in favour of free markets as the most efficient allocaturs of risk and return. They are also the bastion of the econometric approach to managing risk. Basel II is the Accord on capital adequacy due to be introduced by BIS through the BCBS from the end of 2006. This Accord recommends the setting aside of a fixed proportion of capital to cover the cost of operational risk. Are there cheaper alternatives? I will explore some definitions and applications of trust in various contexts and seek to apply these notions to operational risk.
Trust can be described as a particular level of subjective probability with which an agent can assess that another agent will perform a particular action (Gambetta, 1988 in Misztal, 1996 p82). This assumes agents are likely to behave rationally and that trust provides the best strategy for behaving co-operatively. (Misztal, 1996 p85). There is a strong emphasis placed on the incremental nature of the building of trust. (Misztal, 1996 p85). This process needs time and the experience of numerous transactions (Misztal, 1996 p84) This definition accepts trust as a synonym with rational expectations (Ostrom, 1990 in Misztal, 1996 p85) but then goes on to view people as fallible and norm-adapting, and pursuing contingent strategies in complex and uncertain environments. (Ostrom, 1990 in Misztal, 1996 p85) This view expects individuals to make a commitment to rules which describe their mutual rights and obligations which are developed internally in the process of interactions. (Ostrom, 1990 in Misztal, 1996 p85) Trust relationships then monitor and sanction such rules and obligations. This could explain the relationships between the semi-autonomous specialists found on the floor of the NYSE. (Abolafia, 1996 Ch 5). But would not address the informational asymmetries exploited by the hyper-rational bond traders screen trading for large institutions. (Abolafia, 1996 Ch 1).
A distinction needs to be made between the information available to traders within an institution and between institutions. Traders use the institutions sales force, economists and technology to form views on the fundamental value of the bonds they trade. This information is constantly updated and forms the base from which the traders build positions in the market. A certain amount of trust in the judgement and efficiency of the providers of this information is necessary. On the other hand institutional customers are frequently offered incomplete information and their ignorance is often taken advantage of. (Abolafia, 1996 p20). This leads to a culture of mistrust. The customers, such as mutual funds and insurance companies, frequently need to seek information from four or five firms before transacting. (Abolafia, 1996 p20). Furthermore traders not only conceal information, they frequently distort it. (Abolafia, 1996 p20). Showing bids, using the semi-anonymity of screen based trading, to post a higher bid then withdrawing it, the trader hopes others will buy from a third and then attempt to sell in a quick exchange. This sometimes means selling at a loss. (Abolafia, 1996 p21). This is certainly a breach of trust but not illegal. Front running and trading insider information are illegal. Buying a parcel of bonds, marking them up in price and then reselling them to a customer on the certain fore-knowledge the customer is about to purchase is front running. Using information about the economic condition or intentions of a bond issuer not available to the rest of the market is insider trading (Abolafia, 1996 p21). Both are common in financial markets because of the difficulty of detection and add to the culture of distrust.
To what extant is distrust bred by the mere effort to regulate and is there an irresolvable conflict between regulation and trust? (Cvetkovich & Lofstedt, 1999 p166) The argument implies the less regulation the more likely trusting relationships will be built. Some anecdotal evidence suggests the socialization of traders to the unwritten scripts of trustworthy behaviour in bond markets broke down during the period of deregulation in the 1980’s. (Abolafia, 1996 p21). Every time an example of fraud comes to light institutions and regulators seek to institute new systems to guard against the possibility of re-occurrence. This has resulted in a struggle between the proponents of ‘free’ markets who insist institutions should be allowed to fail and those who see the interconnectedness of these institutions and the consequent risk of contagion too high to be left unregulated. In practice there has developed a dual approach. Some institutions are allowed to go under (Barings after Nick Leeson) and Long Term Capital Management which was re-capitalized. The difference appears to revolve around not just the size of the institution but the way the losses were incurred. If the cause was mismanagement or ‘bad luck’ rather than fraud the institutions are thrown a lifeline.
The Nick Leeson and Barings story is a classic tale of operational risk and the breakdown of trust. After some experience of back office management Leeson was allowed to manage the back office and undertake trading in derivatives in the Singapore office of Barings Bank. From the first he set up and ran a false account to hide his losses and other accounts to declare his gains to head office in London. (Risk Glossary.com 2004). At his trial he defended himself by stating his superiors knew what he was doing. They trusted him on the basis of his previous good conduct. An example of the incremental building of trust discussed above. Almost from his first trade he lost money. (Risk Glossary.com 2004). In a classic example of prospect theory (Tversky and Kahneman, 1981) he began to chase his losses. He doubled his bets in a Martingale until he held half the open interest in the Nikkei 200 futures contract and 85% of the open interest in the Japanese Government Bond futures contracts – a total of GBP 827 million. (Risk Glossary.com 2004). Of course other traders knew somebody was out there accumulating these positions. Derivatives are a zero sum game and all the money he lost was transferred to others. Subsequently every institution trading derivatives made the activities of the back office operationally separate from the traders which introduced a level of intra firm regulation that did not allow for the sort of trust that had cost Barings its economic life. I would argue this example suggests there is an irresolvable conflict between the urge to regulate and trust. I would also suggest the irrationality of Leesons’ trades indicated to risk managers and other traders he had ceased to be committed to the rules of his institution which described their mutual rights and obligations and instead was pursuing a contingent strategy at odds with the rational expectations of his employers.
Social ties, notably kith, kin and co-ethnics, increase trust and trustworthiness, and thus mitigate breach of agreement. (Salter 2002 p279) Landa (1994 p101) suggests this is particularly true in traditional markets as a way of coping with contract uncertainty. She expects the exchange networks based on mutual trust to be replaced by impersonal exchange networks based on contract as an economy develops legal infrastructure. Landa (1994 p113). This implies family firms are limited in scale and lack complexity. This generalization is challenged by Wong who found in many settings large business groups are controlled by one or two families. (Wong, 1985 in Smelser and Swedberg, 1994 p463) Whatever the size of institutions, certain results from the usage of trust are common to all, including the reduction of transaction costs. I include the reduction of the hedging premium or insurance cost associated with operational risk in this definition of transaction costs.
The lower transaction costs associated with searches within ethnic boundaries has two characteristics. Members of the same ethnic community are perceived to be more trustworthy (Landa, 1994 p111). Second it is easier to acquire more information from the network of mutual aid associations within the same community. (Landa, 1994 p111). This trust can be characterised as transitive trust because to trust one business partner is to trust her business partner. (Landa, 1994 p111). This builds an expanding network of initially strong but then progressively weaker ties all bound together by trust. (Granovetter, 1974). If Landa is right and impersonal exchange networks based on contract replace ethnic networks based on trust, then these agents should look forward to an increase in transaction costs, including operational risk, without any increase in efficiency.
Until then, ethnic networks based on trust provide a good example of the definitions outlined above. These individuals make a commitment to rules which describe their mutual rights and obligations which are developed internally in the process of incremental interactions. The relationships are then monitored and sanctioned. In the complex and uncertain environments of minorities doing business within larger economic systems these rational agents build deeper and wider behaviours that mitigate operational risks and the costs involved.
McKean conjectures it would be extremely expensive to contractualize every aspect of an agreement. (McKean, 1975 p31). In fact the financial markets should not be included in this generalization. The over-the-counter market for financial instruments is much larger than the exchange traded markets with notional values of derivatives alone being US$128 trillion at the end of 2002. (Beyer, 2003) In these markets the International Swaps and Derivatives Association has developed and distributes to its members a standardised contract. Trades are executed over the phone with the voice recording being the evidence of the offer and acceptance of the contract. Consideration passes at the settlement which is typically by 10 am the following day. Exchange traded markets use a clearing house which forms a novated contract between the parties. There has not been a clearing house fail in the more than 100 years of futures and options trading (Beyer, 2003). These contractual systems are relatively simple, historically robust and have relatively low transaction costs. In the financial markets the transaction cost savings are more to be found within the institution than between institutions.
The Leeson story is an example. According to Hechter (in Misztal, 1996 p86) what is necessary for cooperation in large groups is formal control. However Molm, Takahashi and Peterson (2000 p1398) suggest negotiated terms and strictly binding agreements have the unintended consequence of reducing trust in relationships. For them the risk of incurring a net loss provides the opportunity for exchange partners to demonstrate their trustworthiness. (Molm, Takahashi and Peterson, 2000 p1401) Raise the level of uncertainty and the partners level of trust will increase in a reciprocal exchange. This difference is attributed to the expectation of future interaction. (Molm, Takahashi and Peterson, 2000 p1404) So inside an institution the development of reciprocal exchange should increase trust. By this logic if Leeson had not been a one man band, Barings would still be alive today. But how did the sales force in the Abolafia study feel about the bond traders who systematically communicated incomplete and misleading information? (Abolafia, 1996 p20) I would suggest they would grow increasingly distrustful no matter how many reciprocal exchanges were expected. The traders would have to develop some other form of opportunity to compensate the sales-force for this loss of utility. And here opens the potential for an increase in operational risk. The temptation to engage in collusive fraud, should the opportunity arise, would increase. This leads us back to the need for the introduction of formal controls.
Formal controls have been increasingly implemented in institutions. Chinese walls have been built between analysts and traders to mitigate conflicts of interest. Risk managers have more econometric tools to measure and manage risk. The psychometric testing of traders has increased. These institutions demand their employees make a commitment to rules which describe their mutual rights and obligations but which are enshrined in contracts. This assumes agents are likely to behave rationally and that trust provides the best strategy for behaving co-operatively. But if they behave irrationally, in situations where trust has broken down, then these institutions have a hedge. The cost of implementing these insurance policies is high. But the cost of not having them is higher.
Conclusion
In this paper I have explored theories of trust and asked how they affect operational risk. Without eliminating the use of rational choice theory or individual utility maximization it becomes clear utilizing notions of trust deepens and widens understanding of efficient market behaviour. Informational asymmetries within and between institutions were compared to illustrate the effects on trust and operational risk. Aspects of the debate over regulation and its affect on trust and operational risk were examined. I have argued trust plays an important role in reducing a number of costs associated with operational risk for the small ethnic entrepreneur in traditional markets and the largest and most complex institutions in financial markets, Drawing on stories from bond traders in the 1980’s and the failure of Barings in the 1990’s I have demonstrated how mistrust within institutions can grow and compared that with aspects of the development of trust based on expectations of reciprocity. Contractual arrangements within and between institutions were compared. Leading to the conclusion trust affects operational risk in a number of ways.
References
Abolafia, M. (1996) Making Markets: Opportunism and Restraint on Wall Street, Harvard UP, Cambridge Mass. Chapter 1, “Homo Economicus Unbound: Bond Traders on Wall Street”, and Chapter 5, “Homo Economicus Restrained: Identity and Control at the New York Stock Exchange”.
Baron, J. (1998) “Trust: beliefs and morality.” In A. Ben-Ner and L. Putterman (Eds) Economics, Values and Organization. Cambridge: Cambridge University Press.
Beyer, M. (2003) The Fourth Horseman. Canadian Securities Institute Website accessed may 15 2004 https://www.csi.ca/student/en_ca/infocus/demo/e-editorial.html
Cvetkovich, G & Lofstedt R (1999) Social trust and the Management of Risk Earthscan Publications UK.
DM Review (2003) Basel II: Measuring the Operational Risk
Website accessed May 21 2004
http://www.dmreview.com/article_sub.cfm?articleId=7550
Franklin, Jane (1998) The politics of risk society Malden, Mass. Polity
Press.
Friedland, Roger and A.F. Robertson (1990) Beyond the Marketplace: Rethinking Economy and Society, New York: Aldine de Gruyter
Füredi, Frank (2002). Culture of fear: risk-taking and the morality of low expectation London; New York: Continuum
Gambetta, D (1988) Trust: making and breaking cooperative relations. New York, NY, USA: B. Blackwell
Giddens, A (1991) Modernity and self-identity. Self and society in the late modern age. Cambridge (Polity Press), Website accessed 14 May 2004. http://www.ldb.org/giddens.htm
Glasberg, D and Skidmore D (1998) “The Dialectics of White-Collar Crime: The Anatomy of the Savings and Loans Crisis and the Case of Silverado Banking, savings and Loan Association,” American Journal of Economics and Sociology, 57(4):423-449
Granovetter, M. (1974) Getting a job: a study of contacts and careers. Chicago: Chicago University Press
Hechter M (1987) The Microfoundations of Macrosociology Philadelphia: Temple University Press
Hollis, M (1998) Trust within Reason, Cambridge: Cambridge University Press
Landa, J (1994) Trust, Ethnicity and Identity: Beyond the New Institutional Economics of Ethnic Trading Networks, Contract Law and Gift Exchange. Ann Arbor: University of Michigan Press. Chapter 5 “A theory of Ethnically Homogenous Middleman Group: An Institutional Alternative to Contract Law.”
Lewis, A and Mackenzie C. (2000) “Morals, money, ethical investing and economic psychology,” Human Relations, 53(2): 179-191
Luhmann, N. (1979) Trust Chichester. Wiley
Mansbridge, J. (1999) “Altruistic Trust,” in Mark Warren (Ed) Democracy and Trust, Cambridge: Cambridge University Press
McKean, R. (1975) “Economics of Trust, Altruism and Corporate Responsibility.” In Edmund Phelps (Ed) Altruism, morality and economic theory New York: Russell Sage Foundation
Misztal, Barbara A. (1996) Trust in modern societies: the search for the bases of social order Cambridge, Mass.: Polity Press
Misruchi, M and Stearns L. (1994) “Money, Banking and Financial Markets” in Neil Smelser and Richard Swedberg, (Eds) The Handbook of Economic Sociology. Princeton: Princeton University Press
Molm, L., Takahashi, N. and Peterson, G (2000) “Risk and Trust in social Exchange: An Experimental Test of a Classical Proposition,” American Journal of Sociology, 105(5): 1396-427
Ostrom, Elinor (1990). Governing the commons: the evolution of institutions for collective action. Cambridge: Cambridge University Press
Portes, A (1995a) Economic Sociology of Immigration: A Conceptual Overview in The Economic Sociology of Immigration. Russel Sage Foundation. New York.
Risk Glossary.com (2004) Website accessed may 25 2004
http://www.riskglossary.com/articles/barings_debacle.htm
Salter F.K. (2002) Risky Transactions: Trust, Kinship and Ethnicity Berghahn Books. New York
Smelser, N. and Swedberg, R. (Eds) (1994) The Handbook of Economic sociology. Princeton: Princeton University Press
Taylor-Gooby, P. (Ed) (2000) Risk, Trust and Welfare. Macmillan Press. London.
Tversky, Amos and Daniel Kahneman. (1981) “The framing of Decisions and the Psychology of Choice,” Science 21:453-458
Walker, S.M. (2001) Operational risk Management: Controlling opportunities and threats. Connley Walker: Victoria. Australia.
Williamson, Oliver. (1975) Markets and hierarchies. New York. The Free Press
Basle II
This paper will present an issue study by picking a current concern of The Bank for International Settlements and subjecting it to detailed examination. Capital standards of institutions in the global financial market are the concern of the Basel Committee on Banking Supervision, one of the most important of the Banks committees. After a brief history of BCBS and its role in developing capital standards a critical analysis is made of the new Basel II Capital Accord and the role of BCBS.
The history of the BCBS since its inception in 1974 is one of steady growth in power and reach. It is composed of central bank and regulatory agency representatives from the Group of 10. (BIS, 2004) One important objective of the committee’s work has been to close gaps in international supervisory coverage in pursuit of two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be accurate. (BCBS, 2004) In 1988 the committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord. (BIS, 2004) This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by the end of 1992. (BIS, 2004) This was replaced in 1999 by an expansion of the original Accord to include: minimum capital requirements, which seek to refine the standardised rules set forth in the 1988 Accord; supervisory review of an institutions internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. (BCBS, 2004) These three pillars, Basel II, are to be introduced from the end of 2006. (BCBS, 2004). In the last few years the committee has moved more aggresively to promote supervisory standards worldwide by developing a set of ‘Core Principles for Effective Banking Supervision’ and ‘Core Principles Methodolgy’. (BCBS, 2004 It claims these detailed standards have been implemented by its members and other banking supervisory authorities including many non G10 countires. (BCBS, 2004)
But there are many criticisms levelled at the new Accord from these same non-G10 countries particularly relating to issues of sovereignty and economic philosophy. (Belmont, 2004 p22) Questions asked about both the theory and practice of the role BCBS proposes for itself and Basel II start with who elected them and why should they have power to dictate how national banking systems are regulated. (Belmont, 2004 p22) According to BCBS the adoption of the Accord is voluntary. (BCBS, 1999). But the major donor countries to the IMF and the World Bank are OECD, including the G10. Countries that do not implement the Accord will likely have a harder time getting support for loans unless they progress towards international regulatory benchmarks. (Belmont, 2004 p23) In practice Basel II relies on supervisory oversight and the market discipline imposed by an efficient market. (BCBS, 2004). In developing countries markets and supervisors fail more often. (Belmont, 2004 p24) Developing countries are more prone to greater macroeconomic volatility, greater volatility of external money flows and greater vulnerability to external shocks. (Belmont, 2004 p24) Basel II relies on strong governments and regulatory institutions but these tend to be weak in developing countries. (Belmont, 2004 p24) Bankers and bureaucrats have a greater ability to reap private benefits in these situations. (Belmont, 2004 p24) Skills are weaker for regulators and market players. (Belmont, 2004 p24) Why would developing countries want or need to allow foreign banks to compete on an equal footing in their home economies? (Belmont, 2004 p25) It could be argued, by promoting a level playing field Basel II provides a way for the developed world to get access to new markets for their banks. (Belmont, 2004 p25) Criticisms of the theory and practice of the Accord and BCBS are not restricted to the developing countries either.
In developed countries proponents of free markets ask why one of the goals is a level playing field. (Belmont, 2004 p14) Would competition between regulatory systems ensure market forces create the discipline and innovation necessary to attract banks whilst protecting taxpayers from financial losses? (Belmont, 2004 p14) It could be argued transparency and disclosure are not enough. (Belmont, 2004 p15) Unless investors have money at risk true market discipline is not enforced. (Belmont, 2004 p15) If BCBS is going to manage all the risk it may be the risk premium in the price of bank shares will fall. (Belmont, 2004 p15) Why should these investors enjoy preferential treatment?
There are practical problems as well. The calculation of capital adequacy is based on external and internal ratings, neither of which are proven to be accurate. (Belmont, 2004 p12. Jackson, 2001) External credit rating agencies give inconsistent and conflicting views of creditworthiness and are themselves unregulated. (Belmont, 2004 p12) These agencies can be pressured by debt issuers to get lower cost of funds and debt purchasers to get lower necessary regulated capital allocations thus overestimating creditworthiness. (Belmont, 2004 p12) If bank regulators approve the internal risk management processes of these banks moral hazard could arise because the responsibility passes to the regulator. (Belmont, 2004 p11) There is also no longer an arms length relationship between banks and regulators if the regulator relies on the bank to explain their internal risk management processes. (Belmont, 2004 p13) If the risk is systemically underestimated, Value at Risk type measures become unreliable. (Belmont, 2004 p12) Furthermore operational risk measurement is not possible with current information. (Belmont, 2004 p12) The risk models first accepted by the regulators will encourage herding as banks rush to migrate to these models. (Belmont, 2004 p13) There are no mandatory liquidity requirements. (Belmont, 2004 p13) No direct encouragement of diversification as correlation is only taken into account in a limited way. (Belmont, 2004 p13) Lower capital requirements for household lending may enhance real estate booms and cause household indebtedness to rise, threatening stability. (Belmont, 2004 p13) Basel II does not stipulate how regulators would intervene to maintain adequate capital. (Belmont, 2004 p15). Many of these potential practical problems may not eventuate and it may be others will materialize after the Accord is introduced.
There are also broader criticisms of the Accord. In particular it is too complex, detailed and prescriptive stifling innovation in risk measurement and management. (Belmont, 2004 p9). BIS, BCBS and the process of the formulating of the Accord are too centralized. (Belmont, 2004 p9). The Accord will be costly to implement. (Belmont, 2004 p9). Are national regulators trained to implement the Accord? (Belmont, 2004 p9) The Accord is more complex than Basel I and banks and domestic regulators will have more discretion which may result in an uneven playing field and increase the regulatory forebearance. (Belmont, 2004 p10). These criticisms are more theoretical and are likely to be leveled at any supranational regulatory agency.
There will always be disagreement between those who believe free markets are the most efficient allocators of resources and those who recognise the need for regulation of markets, particularly international financial markets. The increase in volatility in financial markets in the last decade has alarmed many past and present market participants, national governments and researchers. Soros, Stiglitz and Minsky spring to mind. Combined with the potential for contagion from the interconnectedness of the over the counter and exchange traded markets in derivatives and the activiites of unregulated players such as hedge funds suggests a potentail problem of un-heralded proportions. If we could asign a probability to all risk it may be possible to invent the perfect hedge against such a disaster. In the meantime it seems reasonable to support an international agency representing the best ideas on how to mitigate the risks we can identify from previous experience. Certainly BIS and BCBS needs to do more to increase transparancy and utilize techniques increasingly used by Central banks of the OECD, including using presentations to government committees, commisioning and publishing research on their websites and generally raising the profile of the work they are doing. Some thought needs to be applied to how to give real teeth to the international regulator if regulators in national jurisdictions should fall prey to short run political considerations. There are still too many central banks and regulators who are under the complete control of national governments in this writers opinion.
In this paper I have examined what is now a key issue for the Bank for International Settlements through its BCBS – capital standards. A number of criticisms have been levelled at the Basel II Accord to demonstrate the difficulties in bridging the gap between the theory and practise of what they are trying to achieve. Finally some consideration is given to potential improvements
References
Bank for International Settlements (2004) http://www.bis.org/index.htm Website accessed 14 April 2004
Basel Committee on Banking Supervision (2004) Home page. Website accessed
21/03/2004 http://www.bis.org/bcbs/aboutbcbs.htm/
BCBS (1988) ‘International Convergence of Capital Measurement and Capital Standards’. in BCBS, Compendium of documents produced by the Basel Committee of Banking Supervision, Vol. 1. Basel.
BCBS (1999) ‘A New Capital Adequacy Framework’ Basel.
Derivative Strategy.com (2004) BIS Capital Adequacy, version 2001
Website accessed May 25 2004 http://www.
derivativesstrategy.com/magazine/archive/2001/030
The history of the BCBS since its inception in 1974 is one of steady growth in power and reach. It is composed of central bank and regulatory agency representatives from the Group of 10. (BIS, 2004) One important objective of the committee’s work has been to close gaps in international supervisory coverage in pursuit of two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be accurate. (BCBS, 2004) In 1988 the committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord. (BIS, 2004) This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by the end of 1992. (BIS, 2004) This was replaced in 1999 by an expansion of the original Accord to include: minimum capital requirements, which seek to refine the standardised rules set forth in the 1988 Accord; supervisory review of an institutions internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. (BCBS, 2004) These three pillars, Basel II, are to be introduced from the end of 2006. (BCBS, 2004). In the last few years the committee has moved more aggresively to promote supervisory standards worldwide by developing a set of ‘Core Principles for Effective Banking Supervision’ and ‘Core Principles Methodolgy’. (BCBS, 2004 It claims these detailed standards have been implemented by its members and other banking supervisory authorities including many non G10 countires. (BCBS, 2004)
But there are many criticisms levelled at the new Accord from these same non-G10 countries particularly relating to issues of sovereignty and economic philosophy. (Belmont, 2004 p22) Questions asked about both the theory and practice of the role BCBS proposes for itself and Basel II start with who elected them and why should they have power to dictate how national banking systems are regulated. (Belmont, 2004 p22) According to BCBS the adoption of the Accord is voluntary. (BCBS, 1999). But the major donor countries to the IMF and the World Bank are OECD, including the G10. Countries that do not implement the Accord will likely have a harder time getting support for loans unless they progress towards international regulatory benchmarks. (Belmont, 2004 p23) In practice Basel II relies on supervisory oversight and the market discipline imposed by an efficient market. (BCBS, 2004). In developing countries markets and supervisors fail more often. (Belmont, 2004 p24) Developing countries are more prone to greater macroeconomic volatility, greater volatility of external money flows and greater vulnerability to external shocks. (Belmont, 2004 p24) Basel II relies on strong governments and regulatory institutions but these tend to be weak in developing countries. (Belmont, 2004 p24) Bankers and bureaucrats have a greater ability to reap private benefits in these situations. (Belmont, 2004 p24) Skills are weaker for regulators and market players. (Belmont, 2004 p24) Why would developing countries want or need to allow foreign banks to compete on an equal footing in their home economies? (Belmont, 2004 p25) It could be argued, by promoting a level playing field Basel II provides a way for the developed world to get access to new markets for their banks. (Belmont, 2004 p25) Criticisms of the theory and practice of the Accord and BCBS are not restricted to the developing countries either.
In developed countries proponents of free markets ask why one of the goals is a level playing field. (Belmont, 2004 p14) Would competition between regulatory systems ensure market forces create the discipline and innovation necessary to attract banks whilst protecting taxpayers from financial losses? (Belmont, 2004 p14) It could be argued transparency and disclosure are not enough. (Belmont, 2004 p15) Unless investors have money at risk true market discipline is not enforced. (Belmont, 2004 p15) If BCBS is going to manage all the risk it may be the risk premium in the price of bank shares will fall. (Belmont, 2004 p15) Why should these investors enjoy preferential treatment?
There are practical problems as well. The calculation of capital adequacy is based on external and internal ratings, neither of which are proven to be accurate. (Belmont, 2004 p12. Jackson, 2001) External credit rating agencies give inconsistent and conflicting views of creditworthiness and are themselves unregulated. (Belmont, 2004 p12) These agencies can be pressured by debt issuers to get lower cost of funds and debt purchasers to get lower necessary regulated capital allocations thus overestimating creditworthiness. (Belmont, 2004 p12) If bank regulators approve the internal risk management processes of these banks moral hazard could arise because the responsibility passes to the regulator. (Belmont, 2004 p11) There is also no longer an arms length relationship between banks and regulators if the regulator relies on the bank to explain their internal risk management processes. (Belmont, 2004 p13) If the risk is systemically underestimated, Value at Risk type measures become unreliable. (Belmont, 2004 p12) Furthermore operational risk measurement is not possible with current information. (Belmont, 2004 p12) The risk models first accepted by the regulators will encourage herding as banks rush to migrate to these models. (Belmont, 2004 p13) There are no mandatory liquidity requirements. (Belmont, 2004 p13) No direct encouragement of diversification as correlation is only taken into account in a limited way. (Belmont, 2004 p13) Lower capital requirements for household lending may enhance real estate booms and cause household indebtedness to rise, threatening stability. (Belmont, 2004 p13) Basel II does not stipulate how regulators would intervene to maintain adequate capital. (Belmont, 2004 p15). Many of these potential practical problems may not eventuate and it may be others will materialize after the Accord is introduced.
There are also broader criticisms of the Accord. In particular it is too complex, detailed and prescriptive stifling innovation in risk measurement and management. (Belmont, 2004 p9). BIS, BCBS and the process of the formulating of the Accord are too centralized. (Belmont, 2004 p9). The Accord will be costly to implement. (Belmont, 2004 p9). Are national regulators trained to implement the Accord? (Belmont, 2004 p9) The Accord is more complex than Basel I and banks and domestic regulators will have more discretion which may result in an uneven playing field and increase the regulatory forebearance. (Belmont, 2004 p10). These criticisms are more theoretical and are likely to be leveled at any supranational regulatory agency.
There will always be disagreement between those who believe free markets are the most efficient allocators of resources and those who recognise the need for regulation of markets, particularly international financial markets. The increase in volatility in financial markets in the last decade has alarmed many past and present market participants, national governments and researchers. Soros, Stiglitz and Minsky spring to mind. Combined with the potential for contagion from the interconnectedness of the over the counter and exchange traded markets in derivatives and the activiites of unregulated players such as hedge funds suggests a potentail problem of un-heralded proportions. If we could asign a probability to all risk it may be possible to invent the perfect hedge against such a disaster. In the meantime it seems reasonable to support an international agency representing the best ideas on how to mitigate the risks we can identify from previous experience. Certainly BIS and BCBS needs to do more to increase transparancy and utilize techniques increasingly used by Central banks of the OECD, including using presentations to government committees, commisioning and publishing research on their websites and generally raising the profile of the work they are doing. Some thought needs to be applied to how to give real teeth to the international regulator if regulators in national jurisdictions should fall prey to short run political considerations. There are still too many central banks and regulators who are under the complete control of national governments in this writers opinion.
In this paper I have examined what is now a key issue for the Bank for International Settlements through its BCBS – capital standards. A number of criticisms have been levelled at the Basel II Accord to demonstrate the difficulties in bridging the gap between the theory and practise of what they are trying to achieve. Finally some consideration is given to potential improvements
References
Bank for International Settlements (2004) http://www.bis.org/index.htm Website accessed 14 April 2004
Basel Committee on Banking Supervision (2004) Home page. Website accessed
21/03/2004 http://www.bis.org/bcbs/aboutbcbs.htm/
BCBS (1988) ‘International Convergence of Capital Measurement and Capital Standards’. in BCBS, Compendium of documents produced by the Basel Committee of Banking Supervision, Vol. 1. Basel.
BCBS (1999) ‘A New Capital Adequacy Framework’ Basel.
Derivative Strategy.com (2004) BIS Capital Adequacy, version 2001
Website accessed May 25 2004 http://www.
derivativesstrategy.com/magazine/archive/2001/030
1regw.asp
Belmont, D (2004) Basel II’s Dissenting voices: Alternative voices in the global marketplace Presentation to the Asian Banking Summit May 7, 2004 Website accessed 2 June 2004 www.theasianbanker.com/.../FE0B405072B5A57548256E910012
5E31/ $File/
RiskMgt_BaselII-DavidBelmont.pdf
Fratianni, M & Pattison J (2001) ‘The Bank for International Settlements: An assessment of its Role in International Monetary and financial Policy Co-ordination’. Open Economies Review. 12: 197-222 Kluwer Academic Publishers. Netherlands.
Jackson, H.E. (2001) The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy
http://www.law
.harvard.edu/faculty/hjackson/pdfs/2001.Jackson.
Belmont, D (2004) Basel II’s Dissenting voices: Alternative voices in the global marketplace Presentation to the Asian Banking Summit May 7, 2004 Website accessed 2 June 2004 www.theasianbanker.com/.../FE0B405072B5A57548256E910012
5E31/ $File/
RiskMgt_BaselII-DavidBelmont.pdf
Fratianni, M & Pattison J (2001) ‘The Bank for International Settlements: An assessment of its Role in International Monetary and financial Policy Co-ordination’. Open Economies Review. 12: 197-222 Kluwer Academic Publishers. Netherlands.
Jackson, H.E. (2001) The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy
http://www.law
.harvard.edu/faculty/hjackson/pdfs/2001.Jackson.
Credit.Rating.Agencies.pdf.
Website accessed 2 June 2004
Website accessed 2 June 2004
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