Accounting for the Wrong Test
Stress Testing, Statistical Data, Confidence and Monitoring
And now another shoe drops. First Republic Bank no longer inspires confidence. So little can be done because banks are special businesses. A bank’s customers are also its lenders. The moment the customer moves on the bank also loses a lender. And the moment that happens, deposits become scarce. The bank must stop lending and therefore stop being a bank….even as it continues to borrow short-term funds at a high rate.
The recent failure of Silicon Valley Bank has brought to light the critical need for monitoring, not only among bank stocks, but all non-financial corporate securities. While the world continues to reel from the effects of the post-covid inflation and the impending economic slowdown that has often followed a series of robust rate hikes. It would not be surprising to see an increase in corporate balance sheet manipulation, as management team collusion to meet earnings estimates grows in high correlation to an economic slowdown. Consequently, it is crucial to have effective measures in place to detect such malfeasance, including a deep understanding of statistical tools such as Benford’s law and the Beneish M Score.
Benford’s Law
Benford’s law, for those who are not familiar with it, is a statistical principle that observes how the first digits of numbers tend to appear in a non-uniform distribution. Specifically, the digits 1 to 9 are more likely to appear as the leading digit in each set of numbers than any other digit. Thus, if a set of numbers, such as financial transactions or accounting data, violate this distribution, there may be reason to suspect that the data has been manipulated or fabricated.
Beneish M Score
Likewise, the Beneish M Score is another important metric that seeks to identify the likelihood of earnings manipulation. This scoring system analyzes various financial ratios and indicators to determine whether a company’s earnings are abnormally high and therefore suspect. The Beneish M Score is widely used by auditors and regulators to identify potential fraud in financial statements. It is also one of the metrics we use in assessing investment quality before placing equity into portfolios.
The Wrong Test
Bank testing inadequacies and corporate balance sheet manipulation tend to increase during periods of inflation or deflation. By identifying potential areas of financial malfeasance, one can mitigate portfolio risk. But proactive regulators can only improve oversight by testing for the most accurate economic climate. Or as Senator Kennedy of Louisiana pointed out during a recent congressional hearing on bank failures, “the current method of stress-testing banks may be inadequate because these stress-tests simulate macroeconomic shocks like falling GDP, spiking unemployment and defaults in commercial real estate and not for the problem Silicon Valley bank faced; inflation, high interest rates and loss of value from holding interest sensitive government bonds.”
The Fed is expected to continue raising rates. However, The Fed’s next rate hike planned to be announced May 5th may be the last rate hike before a pause, allowing more damage to the economy to take hold before lowering rates-perhaps by the first quarter of 2024. Meanwhile the Fed wants to observe metrics to its stated objective; higher unemployment, a backdrop of slowing economic indicators, and commensurately lower inflation. Will the bank stress tests focus on inflation or deflation after May 5th? Or as Senator Kennedy suggested will these tests be based upon the wrong test? We shall see.
Summary
To emphasize the point of the wrong test, accounting for the stress test given by accounting firm KPMG to Silicon Valley Bank’s parent company, SVB Financial, a clean bill of health for 2022 was announced on February 24, 2023. Less than a month later, March 17, 2023, SVB Financial filed for Chapter 11 bankruptcy due to mounting government bond losses from unprecedented Fed rate hikes. Just ten days later, March 27, another bank was brought in to acquire Silicon Valley Bank’s assets and remaining customers. The collapse went that fast. Clearly accurate risk assessment is important to national economic health.
Therefore, in addition to proper risk assessment by bank customers, equity portfolio diversification is a key ingredient in prudent risk management. For it smooths out returns and helps to improve long-term portfolio performance-even during periods of ongoing bank failure and uncertainty.
Best Regards,
Vaughn L. Woods, CFP, MBA
Vaughn Woods Financial Group, Inc.
2226 Avenida De La Playa
La Jolla, CA 92037
858-454-6900
Investors should be aware that there are risks inherent in all investments such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter are those of Vaughn Woods and Vaughn Woods Financial Group and may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0xxx.
Corporate Finance Institute
Wikipedia
Zerohedge