Prudence is the key to good financial management

According to a leading lawyer, Tommy Thomas, in his letter to Malaysiakini:

"...The reason why contingent liabilities should, as a matter of prudence, be included is because it is in effect "a liability" which may sometime in the future be crystallised.

The largest component under "contingent liabilities" is apparently the guarantee, a long established and widely used financial instrument, which involves three parties; the lender, the borrower and the guarantor.

It arises because the lender is not sufficiently satisfied that the borrower has the financial means to repay his debt.

Accordingly, the lender insists that the borrower's debt be guaranteed by a third party, the guarantor, which then entitles the lender to have recourse against two separate persons (the borrower and the guarantor) in the event that the borrower defaults.

In such a tripartite relationship, the borrower and the guarantor assume legal liability at the time their respective contracts are signed. Thus, the guarantor faces an exposure..."

Rest of his article:

National budget must reflect guarantees by nation

http://www.malaysiakini.com/letters/210678

News after publication of the Auditor General's Report ...

Govt-guaranteed debt breaks Rm100 billion mark

http://www.malaysiakini.com/news/211915

In my humble opinion:

Financial management, accounting and auditing used to be straightforward, and basically, what you see was what you get. Then a person or a company's net worth could easily be calculated with the addition of all assets minus all liabilities. Even then it depended on what was known, but what about those items which had not been revealed? A company's balance sheet might have off-balance sheet items which were undisclosed but which could have disastrous consequences. A lot depended on the integrity of the company's management and its external auditors.

Since then, financial statements of a large group of companies have become too complex to the laymen, and even older accountants have problems understanding them. But let's not fret over that and use simple examples to illustrate my point on the importance of financial prudence.

A person applying for a housing loan might be appraised according to his monthly income to ensure he is able to repay the loan over its tenure. If he has other commitments like HP loan repayments on his car and other major items, then his financial capability could be adversely affected and his prospective housing loan banker might reconsider his application based on such relevant information. His already stretched financial commitments could further be burdened if he had acted as guarantor for others' loans, if and when those borrowers failed to honour their commitments.

In the old days, banks' ability to pay their depositors was never questioned. The banks were required to deposit with Bank Negara, a minimum percentage known as Statutory Liquidity Ratio (now Statutory Reserve Requirement?) which could be used when there was a run on a particular bank. The central bank would guarantee all deposits with the banks under its control. (I believe the old SLR at 20% (when I first read it way back in 1969!) is now the SRR which is currently at 2%)

Recently, it was publicly announced that banks would guarantee any bank deposit up to Rm 60,000, which has since been increased to its present Rm250,000. To me, there is now uncertainty (unlike before) as to whether any commercial bank can pay back all deposits with them. The complexity of banking must have reached a stage where nobody knows exactly whether any bank could withstand a run on it.

There is also concern over Non-performing Loans (NPLs) within banks which are reported to have been sold to third parties, including foreign entities. Cases of housing loan borrowers who found to their shock, that their houses have been auctioned without their knowledge by third parties, showed the extent of the problem caused by this illegal selling of NPLs. Of course, the illegality of such transactions was made legal when sanctioned by a prior blanket approval by the Minister of Finance. But the wisdom of it in terms of financial prudence has yet to be tested.

The situation of NPLs can be serious because of its size. To put it simply, NPL of a lax bank can easily be more than its paid capital and reserves. Just imagine if most, if not all of it, is actually bad or non-recoverable! Doesn't that remind us of the toxic assets of American banks which caused the collapse of world's biggest names in banking?

When dealing with finance, prudence is the key to its sound management. Accountants are trained to follow this important principle. Stocks are valued at the lower of cost or recoverable value; debtors are stated, less any known or possible irrecoverable portion; incomes are recognized when legally proper to do so and expenses or commitments to spend properly provided for.

By extension, shouldn't this vital principle of prudence be applied to our country's financial management? There are currently some complaints about our national debt being too close to, if not already exceeding the approved ratio; some believe the national debt was intentionally understated, especially with the omission of contingent liabilities in the form of guarantees given by the government.

Update: As they say, a picture shows more than a thousand words, the following graphic (courtesy of Martin Jalleh and Malaysiakini) shows our unhealthy public financial situation:

Question: Are there any other hidden liabilities which we are unaware of?

The pensioners and other beneficiaries of BR1M and other handouts are happy, but they wonder where the money is coming from!

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