Letter number 81 of April 2014


News : Six years after the 2008 financial crisis, what are the pillars of financial theory that have been seriously undermined?

The 2008 financial crisis not only seriously shook up Lehman Brothers, Bear Stearns, Wachovia, Washington Mutual, Merrill Lynch, Citigroup, UBS, RBS, ING, RBoS, IKB, Northern Rock, Dexia, Fortis, Commerzbank, Bank of Ireland, and many others.  In our view, it also called into question four key beliefs or postulates relied on by financial theory:

  • The belief that on condition of always offering a good risk/return profile, it is always possible to find liquidity on the market;

  • The belief that as markets always provide fair value at all times, this value can be introduced widely on company balance sheets;

  • The belief in the existence of a risk free financial asset;

  • The belief that the normal (or Gaussian) distribution represents the distribution of rates of return on the market.


1/ The belief that liquidity is always present. This belief was partially challenged on 9 August 2007, when BNP Paribas temporarily suspended the valuation, and accordingly the marketing, of 3 funds that had partially invested in subprimes[1]  following a sudden halt in subprimes transactions as of 6 August.  Some people were keen to see this as the beginning of the crises, or even its cause, in the same way as when the wise man points to the moon, the idiot looks at his finger.

In another register, we remember a financial director of a large Eurostoxx 50 company, in mid-November 2008, telling around a hundred of our students that he didn’t know what his group was going to do at the end of the month in order to be able to pay the wages of tens of thousands of employees.  We can’t remember whether we were more amazed at the fact that such a confidence could have been made in public in an explosive financial context or by the fact that such a powerful group was having to turn out its pockets and beg for cash.

There are many of financial managers who spent sleepless nights and will never forget the lesson that they learnt – liquidity is like water on sand, it’s there when it’s there, but it can disappear in an instant at any time.  Which is why products to ensure against the risk of illiquidity have been developed, such as cash kept on the balance sheet for companies and on deposit at the Central Bank for banks, and even for very large groups, the acquisition of a bank so as to be able to deposit their cash at the Central Bank (Siemens, Airbus), confirmed credit lines that are not drawn down, etc.

2/ The belief in the systematic supremacy of fair value

If markets are able at all times to provide a fair value for any asset, then it is not unreasonable, in certain cases, to want this value to be reflected on the balance sheet of the entity holding this asset.  It is in fact possible to sell this asset at any time at its market value. This does introduce the volatility of financial markets into the balance sheet, and even the income statement, if the counterpart of the change in value is not an item on the statement of comprehensive income[2]. On the other hand, we could claim that these assets are recorded on the balance sheet only at the value that it is possible to obtain for them, and not a theoretical, historical value like an amortised or provisioned acquisition cost.

But if at any given time, the financial markets collapse and cannot give a reliable valuation for these assets, this advantage disappears, the fair value becomes just as theoretical as an amortised cost and the volatility that is introduced no longer has a positive counterpart.

The domino effect of a drop in liquidity is a drop in fair value.

3/ The belief in the existence of a risk free financial asset

Its existence is central in the capital assets pricing model (CAPM) which today remains, among practitioners of finance, the only tool for valuing the required rate of return on any asset[3], while among researchers, it is the Fama-French model that is by far the most used[4]. This model is, however, more complicated to implement and is not widely taught, so the existing dichotomy may last well into the future.

We have already[5] affirmed our conviction that it was no longer possible to behave like ostriches when determining a risk-free asset, often seen as a 10-year government bond on the pretext that they have greater liquidity and a long duration, similar to that of shares. OK, so we can go along with the risk of fluctuation in the value of a 10-year bond (which is not theoretical given its term), with the risk of inflation or with the risk of reinvesting coupons. So be it. 

But the discovery that the solvency risk of a certain number of countries, previously rated AAA or others whose debts were listed as if they were rated AAA, means that it is no longer reasonably possible to consider a long-term government bond like a risk-free money rate.  This is just too much!

Let’s not be naïve.  For years we’ve been saying that the concept of a risk-free asset is a matter of opinion. To say that there is no risk is to be excessively sure of oneself or to be unable to think about the future, two very serious faults for an investor.

So we recommend taking as the risk-free money rate for determining the interest rate to be required on an asset, a short-term rate, such as 1-month Treasury Bills of an AAA rated government, for which the risks of solvency, fluctuating value, inflation and reinvesting of coupons, are negligible or nil.

4/ The belief that normal distribution represents the distribution of rates of return on the market.

There many attractive aspects about normal distribution or Gauss’ distribution – simple representation (a curve in the shape of a symmetrical bell), is only defined by its average and its variance and describes many facts about nature or human life well.

Nevertheless, in the area of stock market behaviour, it underestimates the probability of extreme events. So, a variation of 5% or more in share prices should only happen once in every 15 years. There have been 48 of such variations on the CAC 40 over the last 20 years. There should only be a fluctuation of over 6% once every 260 years. There is in fact an average of one every year. 


In other words, the real breakdown of rates of return show distribution tails that are much fatter than assumed under normal law.  Which is why alternative laws have been developed, such as Fréchet’s law or Benoît Mandelbrot's fractals.


[1] For more on subprimes, see the Vernimmen.com Newsletter n°28, November 2007.

[2] For more on the statement of comprehensive income, see the Vernimmen.com Newletter n°69, September 2012

[3] For more on the CAPM, see chapter 19 of the Vernimmen

[4] For more on the Fama French model, see chapter 19 of the Vernimmen

[5] In the Vernimmen.com Newsletter n°71, January 2013


Statistics : Employees representation on boards of directors

If you thought that Europe is divided according to language, religion, currency or geography, you should revisit the topic with the help of this graph. Europe is divided between countries where employees’ representatives seat on board of directors and countries where they do not!

And the difference between the 2 blocs is pretty wide: it reaches 30 points between Greece the last country in the first bloc and France, the first one in the second bloc. 30 points is nearly the average percentage in Europe (36% to be exact), which simply means that the average has absolutely no value in this case.

 Source: European federation of employee share ownership, 2013.

Research : Credit crisis or demand shock

With Simon Gueguen – Lecturer-researcher at the University of Paris Dauphine

The financial crisis that began in 2007 saw both the collapse of credit and a fall in corporate investments.  The mechanism by which the crisis was transmitted is most often described by economists as follows: the sub-primes crisis led to banks making losses on toxic assets, which reduced the capacity of the banking system (or more generally the lending markets) to lend to firms, which in turn led to a decline in investments.  Accordingly, the fall-off in investments should be more pronounced for firms that are more reliant on bank financing. This month we present another theory which was put forward in a recent publication[1]: The sub-primes crisis caused a negative demand shock on US households, which lead to a downward revision of the expectations of firms, which then cut their investment programmes and consequently their demand for financing.  The causality is inversed – it’s the drop in investments that explains the drop in borrowing.

Kahle and Stultz analyse a large sample of quarterly data for non-financial US firms between July 2007 and March 2010. They show that spending on investment by firms evolves during the crisis in the same way, whether the firms financed their operations, before the crisis, using debt or equity.  Firms that rely on bank loans do not experience a bigger drop in investments than other firms.  In order to identify companies that "rely on bank loans", Kahle and Stultz make use of several criteria. They look at firms that have contracted two loans from the same bank during the years preceding the crisis, firms that are highly leveraged, and small firms that are not rated by the rating agencies.  According to the generally accepted theory behind the credit crisis, these firms should have seen their investments decline during the crisis to a greater extent than other firms. However, this is not the case.

Again, according to the generally accepted theory, companies that rely on bank loans should have experienced a decline in borrowing at the start of the crisis, and sought to make up for this decline by issuing equity or by using their cash reserves.  This is not what is observed either.  During the “first year of the crisis” (from mid-2007 to mid-2008), so before the effects on demand had materialised, these firms experienced (like others) a drop in their equity issues.  In the following period, the period that followed the collapse of Lehman Brothers (Kahle and Stultz took the last quarter of 2008 and the first quarter of 2009, leaving the third quarter of 2008 out of the scope of their analysis), the investment behaviour of firms that rely on bank loans is no different from that of other firms. Surprisingly, they find that according to the financial leverage criteria, the inverse is in fact true – firms carrying no debt before the crisis see their spending on investments fall by 39%, while firms carrying debt only experience a decline of 29%.  If the credit crisis was the driving force behind this phenomenon, we could have expected a decline in investments that was more pronounced at firms that rely on bank loans, all the more so since the depreciation of assets had made using them as collateral more difficult.  For Kahle and Stultz, the similarity of behaviour is more compatible with demand shock as an explanation of the crisis, since demand shock affects firms independently of their mode of financing.

Finally, when Kahle and Stultz refer, with a touch of optimism, to the “last year of the crisis” (the last three quarters of 2009 and the first quarter of 2010), while tensions fall on the credit markets and the equity markets rebound, corporate investments continue to fall.  Accordingly, it is not a problem of access to credit that is causing the fall-off in investments, but negative expectations about future opportunities.

This article has the merit of suggesting another reason for the spread of the crisis than that which is generally put forward, demand shock rather than credit crisis.  It does, however, remain confined to the US market. The issue of how the crisis was transmitted on world markets remains open.


[1] K.M.KAHLE, R.M.STULZ (2013), Access to capital, investment, and the financial crisis, Journal of Financial Economics, vol.110, pages 280-299


Q&A : How should investment subsidies be treated in financial analysis?

An investment subsidy (or grant) is an amount of money paid by a third party, often the state authorities, to a firm in order to help it to acquire or create a fixed asset.

Under IFRS, investment subsidies can be accounted for as a deduction from the book value of the asset in question or recorded under equity capital and progressively written back on the income statement at the same rate and over the same period as the amortisation of the fixed asset being financed in this way.

In financial analysis, we advise you to deduct this investment subsidy from the amount of the fixed asset.

This money was not provided by the shareholders or by the lenders. It was provided by a third party for its own reasons and for which, in exchange, it obtained nothing in particular in terms of rights to the company’s cash flows.  All that is obtained is that the investment be made.  From a financial point of view, this investment subsidy has no place on the liabilities side of the company’s balance sheet.

Moreover, the amount invested by the company corresponds to the amount of the investment less this subsidy, an investment which would (probably, perhaps) not have gone ahead if the subsidy hadn’t been paid.  This is one of the methods used by accountants to treat the investment on the income statement since annual depreciation and amortisation at the same time find a partial counterpart in the gradual write-back, at the same pace, of the subsidy. So, all in all, over the duration of the depreciation, there is a depreciation charge that corresponds to the amount of the investment following deduction of the investment subsidy.

In the area of valuation, when discounting free cash flows, corporate income tax should be correctly modelled and you should neutralise, in the same way as depreciation and amortisation, the gradual write-back of the investment subsidy on the income statement, which is anything but a cash flow.  In terms of relative methods and making the assumption that only the company to be valued has received an investment subsidy, to derive the P/E ratio, the write-back of the investment subsidy net of tax must be subtracted from net income.  For the EBIT multiple, we reduce depreciation and amortisation by the amount of the subsidy write-back.  No adjustment is required for the EBITDA multiple which comes before these purely accounting entries. 

When going from the value of capital employed to the value of equity capital, we deduct the balance of the investment subsidy that has not been transferred to the income statement, multiplied by the relevant corporation tax rate in order to take into account future taxation which will prompted by its transfer onto the income statement.