Governance in Corporate Sector

Traditionally approach of corporate governance in the financial sector often involved the regulator or bank supervisor relying on statutory authority to devise governance standards promoting the interests of shareholders, depositors and other stakeholders.

Corporate governance in the banking and financial sector differs from that in the non-financial sectors because of the broader risk that banks and financial firms pose to the economy. As a result, the regulator plays a more active role in establishing standards and rules to make management practices in banks more accountable and efficient. Unlike other firms in the non-financial sectors, a mismanaged bank may lead to a bank run or collapse, which can cause the bank to fail on its various counterparty obligations to other financial institution and in providing liquidity to other sectors of the economy.

For reason of financial stability, national banking law and regulation should permit the bank regulator to play the primary role in establishing governance standards for banks, financial institutions and bank/financial holding companies. The regulator represents the public interest, including stakeholders, and can act more efficiently than more stakeholder groups in ensuring that the bank adheres to its regulatory and legal responsibilities.

Another contrasting view is need for remedies should be strengthened to enforce corporate governance standard by banks. This would involve expanding the scope of fiduciary duties beyond shareholders to include depositors and creditors.

Increasingly, international standards of banking regulation are requiring domestic regulators to rely less on a strict application of external standards and more on internal monitoring strategies that involve the regulator working closely with banks and adjusting standards to suit the particular risk profile of individual banks. Indeed, Basel II emphasis that banks and financial firms should adopt, under the general supervision of the regulator, internal self-monitoring systems and processes that comply with statutory and regulatory standards. Basel II provides for supervisory review that allows regulators to use their discretion in applying regulatory standards.

International Standards of Corporate governance for banks and financial institutions

Ø  Organisation for Economic Co-operation and Development

Ø  Basel II Capital accord Pillar II

o   Regulatory framework for banks

§  Internal Capacity Adequacy Assessment Process (ICAPP)

§  Risk management

o   Supervisory framework

§  Evaluation of internal systems of banks

§  Assessment of risk profile

§  Review of compliance with all regulations

§  Supervisory measures

Ø  National financial regulation and corporate governance

Ø  Company law

Ø  Anti-money laundering rules

http://www-cfap.jbs.cam.ac.uk/publications/downloads/wp17.pdf

Uncertainty and Speculation

Uncertainty is inability to forecast future event. Uncertainty means the position and momentum of a outcome cannot be simultaneously measured with arbitrarily high precision. Uncertainty hovers around every investment/lending. The longer the time duration the more uncertain will be the expected associated returns. So, how do investors/lenders cope with this situation? There are tools available to decide on deal, which involves uncertainties.

Uncertainty is more difficult to plan than risk. There are several tools and techniques available to deal uncertainty in project appraisal. Some of them are: payback period, sensitivity analysis, simulation and iteration. Though using these tools we cannot end up with precise outcome but at least we can limit amount of uncertainty surrounding investment.

Structures and methods of meeting uncertainty

The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from statistics of past experience), while in the case of uncertainty this is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique. The best example of uncertainty is in connection with the exercise of judgment or the formation of those opinions as to the future course of events, which opinions (and not scientific knowledge) actually guide most of our conduct. Now if the distribution of the different possible outcomes in a group of instances is known, it is possible to get rid of any real uncertainty by the expedient of grouping or "consolidating" instances. But that it is possible does not necessarily mean that it will be done, and we must observe at the outset that when an individual instance only is at issue, there is no difference for conduct between a measurable risk and an unmeasurable uncertainty. The individual, as already observed, throws his estimate of the value of an opinion into the probability form of "a successes in b trials" (a/b being a proper fraction) and "feels" toward it as toward any other probability situation.

http://www.econlib.org/library/Knight/knRUP.html

Understanding risk, uncertainty and profit/cash-flows together is the best way to understand basic of financial studies. The essence of speculative behaviour is to balance of uncertainty and expected gain.

In general, speculation means forming opinion without knowing fact. Traditional theories suggested that speculation existed in forward market. Presently price of commodities surge and slump following the speculative behaviour of the investors in commodity market. The same way investment decision is affected by speculative behaviour of investors/lenders. Speculation further helps reduce amount of uncertainty involved in specific project. However provided unexpected result at times speculation can create financial hardship.

Risk and Return

Guess it, why developed countries enjoy privilege in interest rate and developing countries are charged with very higher interest rate as compared to those of developed nations. Obviously, the answer is the risk factor involved in the transaction. The debt to developed nations are unlikely to default whereas to those of developing countries are most likely to default leaving less probability of recovery. It is same when an individual lends to other individual or invests in any available project. Financial institutions follow the same policy.

Investors or fund providers always look at the certainty of recovery of their fund and the benefit expected for their investing/lending. Cash flow reflects the availability of money at particular time in past, present and future. Therefore, finance is coherently linked with the cash flow statement. Investors and financiers takes their decision based on the future cash position of the firm. However, for every projection uncertainty exists. Before taking account of uncertainty  investors/lenders need to account for associated risk.

Standard deviation is statistical tool, which measures the risk of a project/investment. Higher value of standard deviation reflects higher risk associated with the project and lower value represents lower risk. There is tradeoff between risk and return. Risk is directly linked to return. Higher the risk, higher the return and lower the risk, lower the return.

No investment/financing can avoid market risk. Market risk exists in various forms. It is also known as systematic risk. In general risk free rate together with market premium represents systematic risk. It cannot be avoided in any investment and financing. Unsystematic risk also exists in investing and financing project. They are risk specific to the project represents operational inefficiencies. This risk can be avoided by investing in diversified projects. Investing in number of projects help diversify away the unsystematic risk.

In return for accepting systematic risk, an investor can expect different category of return. This can be illustrated in a risk return pay-off matrix. For example, a risk-averse investor will expect to earn a return, which is higher that return on risk free investment. Risk-averse investors are prepared to accept risk, in exchange for higher returns. The return on the risk free investment is supposed to be equal to the return form government bond.  A risk-seeker will be satisfied to earn lower premium for the equal weight of risk as that of the risk-averse investor. CV (coefficient of variation = standard deviation/mean)  is a unitless measure of risk, it permits comparison between reward types and risk for different projects. CV demonstrates better predictor of choice behavior.

The Cash Flow

Finance and investment is the study of cash (money) and equivalent and the reward (return) for

the best use of available fund. Therefore, finance primarily focus on the study of time value of

money. This is also because finance providers/investors value cash flow rather than profit or loss.

Discounting and compounding are simple tools used to define time value of money.

The time value of money is a fundamental concept in finance and it influences every financial

decision made. Time value of money reflects the idea that money available at the present time is

worth more than the same amount in the future due to its potential earning capacity. This core

principle of finance holds that, provided money can earn interest, any amount of money is worth

more the sooner it is received.

Finance and investment is the study of cash (money) and equivalent and the reward (return) for the best use of available fund. Therefore, finance primarily focus on the study of time value of money. This is also because finance providers/investors value cash flow rather than profit or loss. Discounting and compounding are simple tools used to define time value of money.

The time value of money is a fundamental concept in finance and it influences every financial decision made. Time value of money reflects the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.

Interest is the compensation for investors being deprived of using their money. Interest rate fluctuates over time. Generally, higher the period higher will be interest rate. Therefore, bonds in same class with different maturity have different interest rates. Two different nations can have significantly different interest rates in practice. Two different financial institutions within same jurisdiction can also have marginal different interest rates.

The purchasing power of money deteriorates over time. General index provides an estimation of the depletion of money value over time. There are specific indices too. They define devaluation of money in specific sectors or the depletion of money value with respect to specific product.

Investors love to hold money for different reasons. This character of investors is known as liquidity preference. Investors need to hold money for future unavoidable transaction, precautionary motive and speculation in a hope to earn a higher return. Being deprived of these opportunity investors demand higher return for their investment.

Once a suitable rate for investment/financing is defined, it is used for discounting and compounding the cash flows. Discounting is the process of converting future cash flows to present time whereas compounding means converting cash flows to certain future time both using the defined rate of interest.

The cash flow reflects the availability of money at particular time in past, present and future. Therefore, finance is coherently linked with the cash flow statement. Investors and financiers takes their decision based on the future cash position of the firm. However, for every projection uncertainty exists.

Introuction to Finance

Learning finance is fun. It involves lots of calculations and prudential judgement. Calculations can require simple arithmetic tools to complex statistical tools. The good thing about calculation is that they follow specific rules. However, at times when we need to irritate calculations, it can be cumbersome repeating task again and again. Use of advanced computerized tools and techniques becomes handy to play with this type of problems.

Unlike calculations, prudential judgement requires skills and techniques developed over time. They do not follow specific rules and therefore are likely to be guided by principle and instinct of the decision maker, which needs to align with goal of company. Selecting the best approach out of given multiple alternatives by matching risk and return profile of the company is challenging. Therefore, finance personnel require to be equipped with advanced decision making and statistical tools to cope with the changing role in present turbulent financial world.

Financial statements help cast the future picture of an organisation looking back to the history of the organisation. It guides decision maker outside the organisation and those within the organisation and helps align their interest together.

Objective of financial statements

The objective of general purpose financial statements is to provide information about the financial position, financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions. To meet that objective, financial statements provide information about an entity's: [IAS 1.9]

• assets
• liabilities
• equity
• income and expenses, including gains and losses
• contributions by and distributions to owners
• cash flows

That information, along with other information in the notes, assists users of financial statements in predicting the entity's future cash flows and, in particular, their timing and certainty.

Finance and investment is the study of cash (money) and equivalent. Therefore, finance primarily focus on the study of time value of money. This is also because investors value cash flow rather than profit or loss. Discounting and compounding are simple tools used to define time value of money.