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Confronting The Entitlement Conundrum – Why Social Security May Be America’s Financial Weapon of Mass Destruction
By Marquis Codjia
Warren Buffett, the billionaire investor and long-time Chairman of conglomerate colossus Berkshire Hathaway, emphatically stated in 2002 that derivatives were “time bombs, both for the parties that deal in them and the economic system”. Given the deleterious role these securities had in the recent economic crisis, the “Oracle of Omaha” certainly evinces prescience in addition to his mythic business acumen.
Yet, what will likely choke off economic growth in the U.S., and by percolation, usher in global economic disequilibria, is managing mammoth entitlement benefits due to – or rather, promised to – millions of Americans over not only a year or two, but decades in their lifetimes, once they face thorny existential episodes such as illness, old age, disability, or loss of employment.
Of all government-steered social schemes, Social Security – the federal Old-Age, Survivors, and Disability Insurance (OASDI) program – is the largest, claiming 20% of the national budget in 2009 or $678 billion, right after defense (23%). Other known schemes are unemployment benefits, Medicare and Medicaid.
A conceptual understanding of Social Security is helpful to gauge the dynamics at work in the entitlement debate. Simply explained, Social Security allows retirees to earn pension income from contributions made by current workers – via specific payroll taxes. Understandably, the system remains balanced if contributions made exceed benefits paid – as is currently the case.
However, current projections posit a funding gap starting in 2016 – in other words, expenses will outrun revenues, thus coercing the country into seeking external funds (from new loans or cuts in other programs). Worse, successive governments have borrowed and used up over the years cumulative surpluses held in the Social Security Trust Fund.
The funding deficit is caused by a panoply of factors, the most important of which are the increase in life expectancy, the lowering birth rate, and aging baby-boomers (resulting in fewer workers paying for more retirees).
What’s flummoxing is that the current political elite – like their forerunners in both parties – seem to be voluntarily embroiled in partisan ramblings, and gladly enjoying esoteric rhetoric that renders the populace obtuse, and discredits the urgency and criticality of the social security debate. Consequently, our most intellectually dynamic citizens do not give this topic the socio-economic import it deserves.
The ensuing status quo threatens to turn a tractable conundrum into a veritable crisis – a “time bomb” into a “financial weapon of mass destruction” against America’s social fabric. Former and current Fed chairmen, fortunately, fathom the essence of the matter; thus, Alan Greenspan advocates a mix of measures to bring entitlement programs under control and ensure long-term economic prosperity, while Ben Bernanke warns that “Americans may have to accept higher taxes or changes in entitlements… to avoid staggering budget deficits.”
Several elements form the disquieting body of thoughts that justifies the hyperbolic, or apocalyptic, formulation used in this analysis.
First, the absence of a real, serious forum to gauge the merits of viewpoints engaged in the Social Security overhaul disputation. As noted earlier, this status quo seems to be furthered, at the very least, by consecutive administrations for the past three decades, because either the issue is thorny and politically unpalatable to constituents or elected officials deem it of lower priority. In sum, they dare not venture topics that may derail re-election prospects.
To fill the rhetorical void, snippets of partisan parlance are interjected here and there, mainly to polarize citizens and eschew a thorough debate. One such snippet is the notion that Social Security should be privatized and entrusted with professional portfolio managers because the government should let free-market decide and any form of public management of the behemoth fund is a type of communist intervention intolerable in capitalist America. In this article, the pros and cons of this argument cannot be evaluated with granularity but factual observations reveal the latter’s practical limits. It’s easy to wonder what financial devastation the country would have suffered had the Fund been invested in the stock market before the recent mini-crash. It’s also easy to observe how effective a manager the government can be by analyzing operational results at the Federal Employees Retirement System (FERS), the Army Medical Department, Medicare, and Medicaid, all of which remain sound programs.
Second, the much needed overhaul of the IRS and the country’s tax collection scheme is taking longer to occur, and this delay, coupled to the ongoing government waste at the federal, state, and legislative levels, annihilates any serious endeavour to cut budget deficits.
Next, the systemic spectre of a vicious cycle looms. If the ratio of retirees to active workers grows excessively, there will be fewer contributions to pay pension benefits, and such a reduced purchasing power will yield lower private consumption. Companies will then be forced to cut their workforce if sales are lethargic, and the smaller remaining workforce will contribute even less to the Social Security Fund, and so forth.
Fourth, the Fed – as the lender of last resort – can lend to the U.S. Treasury should public finances deteriorate but it can’t sustainably keep printing money via its quantitative easing tactic lest the dollar tumble on defiance from capital markets and heightened inflation.
Fifth, the country’s incapacity to lower its trade deficits will likely not be solved in the near future because the American industrial complex is currently unable or disinclined to produce superior goods affordably, and opening up U.S. markets to foreign suppliers serve as geostrategic levers in international discussions.
In the end, entitlement specialists and those well-versed in the Social Security issue ask the following: why aren’t authorities implementing the Social Security Trust Fund’s proposal (2009 Report) to marginally raise the tax rate or the salary cap on payroll tax in order to fix the funding gap? For example, raising the payroll tax rate to 14.4% in 2009 (from 12.4%) or cutting benefits by 13.3% would fix the program’s gap indefinitely, while these amounts increase to ca.16% and 24% if no changes are made until 2037.
From Wall Street to Dubai – The Lucrative Idiosyncrasies of Islamic Banking
Religious limitations within Islamic jurisprudence have kept Islamic banks more cash awash than their risk-taking Western counterparts after the recent economic hubbub, but gradual reforms need to take place for the industry as a whole to experience a structurally sustained positive growth in the future.
By Marquis Codjia
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A supranational symposium of key financial players took place recently (March 2nd and 3rd, 2010) at the posh King Hussein Bin Talal Convention Center on the shores of the Dead Sea, circa 25 miles southwest from Amman, Jordan.
The event received trifling media interest from major western news outlets; however, behemoths in the global banking industry were closely eyeing pivotal decisions that may be announced in the final communiqué.
They were right to do so.
The gathering, the first Islamic Finance and Investment Forum for the Middle East, occurred in economically healthy and politically stable Jordan – a prominent ally of the West in a geostrategically susceptible region, – which enjoys the highest quality of life in the Middle East and North Africa Region, according to the 2010 Quality of Life Index prepared by International Living Magazine.
Another essential factor to heed lies in the fact that participants were among the crème de la crème of the Islamic financial marketplace, a group of over 350 bankers and experts from 15 countries that are spearheading transformational shifts in an economic sector likely to experience solid growth in the foreseeable future.
A bird’s eye view of Islamic banking is utile to fathom the industry’s core dynamics.
Islamic banking – and to a larger extent, Islamic finance – is deeply rooted in Islamic economics and quintessentially governed by Sharia, a legislative corpus that encapsulates the religious precepts of Islam.
Sharia – or its financial section known as Fiqh al-Muamalat (Islamic rules on transactions) – allows financial intermediaries to engage in any form of economic activity so long as they don’t charge interest (Riba) and shun businesses implicated in forbidden (Haraam) undertakings.
Sharia strongly furthers risk sharing among investors and economic transactions collateralized by tangible assets such as land or machinery but outlaw derivative financial instruments.
A derivative instrument is a product that derives its value from other financial instruments (known as the underlying), events or conditions. It is mostly utilized for hedging risk or speculating for profit. The recent turmoil in global capital markets and the ensuing socio-economic pandemonium owe much of their existence to a type of derivative called Credit Default Swap (CDS).
Viewpoints alien to the Muslim world may find Sharia restrictions deleterious for sustained economic development because what Muslim jurisprudence defines as vice (gambling, adult filmography, alcohol, etc.) not only plays a vital role in many countries’ GDPs but is also an arguable social and temporal concept.
Notwithstanding, a plethora of observers now contend that constraints within Islamic finance have successfully shielded Sharia-compliant institutions from the recent economic meltdown while keeping their coffers cash awash.
Several factors support a potential Islamic finance boom, including skyrocketing deposits from denizens of oil-rich populated countries, numerous infrastructure projects and the emergence of a large middle class.
UK-based International Financial Services London estimates that Sharia-abiding assets have grown by 35% to $951 billion between 2007 and 2008, even though the industry “paused for breath” in 2009 amid the ongoing economic lethargy.
According to Mohammad Abu Hammour, Jordan’s minister of finance, the Islamic banking sector witnesses an annual growth rate of 10-15 % and there are currently over 300 Islamic banks in more than 50 countries, with large concentrations noted in Iran, Saudi Arabia and Malaysia.
Most of those banks and financial intermediaries are owned by native shareholders but growing swaths of the Islamic banking sphere are being populated by specialized sections of “ordinary” full-service Western banks.
HSBC Amanah, the Islamic finance arm of HSBC, is an illustration of that trend.
Islamic banking is highly profitable and the heightened foreign interest conspicuously corroborates the notion that the industry is bound to expand once emerging nations within the Muslim world are willing and able to use their gigantic cash reserves to structurally develop core sectors of their economies.
Nonetheless, many pending issues are still crippling the Islamic finance sector and prevent it from exceeding the 1% share it currently holds in global banking business.
The first relates to the need for Islamic banks to devise risk-hedging strategies – especially those engaging in cross-currency transactions – and instruments that are compliant with regulatory precepts. Specialists within the industry have to be creative because derivatives, a major hedging tool, are prohibited by Sharia. Progress in that area is still timid.
Second, Islamic scholars need to devise and inculcate a homogenous body of legislation to financial agents to avoid asymmetric disadvantage in the marketplace. The immensity of such a task cannot be underrated because Islam has multiple schools of thought and divergent interpretations of certain religious precepts can often turn out to be insurmountable stumbling blocks.
Sunni Islam is the largest branch of Islam with at least 85% of the world’s 1.5 billion Muslims although the endogenous variety of schools of thoughts often creates a diversity of views.
If a bank located in Sunni Saudi Arabia finds itself at a regulatory disadvantage versus an Iranian bank ruled by the precepts of Shiite Islam or a financial institution in Kharijite Oman, then evidently fundamental market disequilibria will emerge.
Third, the sector needs to harmonize practices to grow. Uniformity is needed not only in regulatory oversight but also in accounting and risk standards, both internally (within the Islamic world) and externally (vis-à-vis Western or other regional financial zones). A practical example will be to seek compliance with I.F.R.S. (International Financial Reporting Standards) and Basel II Banking Accords.
Finally, Islamic banks will need to engage in a sophisticated, well-targeted communication campaign aimed at educating skeptical U.S. and E.U. regulators (primarily), as well as prospective clients in the Western hemisphere. This effort will be pivotal in shifting public perception of the quality and positioning of their products and services and in expunging the stigma that erstwhile (and current) geopolitical happenings may have placed on the “Islamic brand”.
Dr. Abu Ameenah Bilal Philips on Interest and Islamic Banking
Competitive Asymmetry vs. Corporate Strategy: The Perilous Nexus in a Treacherous Chasm
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by Marquis Codjia
In the past, corporate strategists sought to maximize overall firm profitability by devising the best modus operandi that will help achieve results efficiently and effectively. Such a strategy routinely took advantage of the endogenous analogies of a homogenous market or geographic zone, such as culture, regulatory landscape, uniformity in fiscal or monetary policies, and socio-political affinity.
This system of similarities was observed in North America between Canada and the United States, in Western Europe prior to the Schengen Accords that led to higher economic integration within the European federation, and Japan within its Asian economic and geopolitical fiefdom. It has proven very fruitful for many a company because the strategic proximity afforded them lower implementation costs and higher profitability.
Nowadays, globalization along with its cohort of uncertainties is rebalancing the economic landscape and swinging the strategic pendulum in unlikely whereabouts. Globalization forces companies to review their tactical practices because of inherent execution difficulties in cross-cultural environments.
Tactics ought not to be mixed up with strategy. The former deals with detailed maneuvers to achieve aims set by the latter.
The need to control and instill a grain of homogeneity in the global marketplace has forced Western governments – mainly – to found organizations that will promote anti-protectionist measures and greater legislative coordination in world’s business. World Trade Organizations (WTC), North American Free Trade Agreement (NAFTA), and Eurozone are examples of such institutions or zones.
Though these international bodies have help catapult capitalistic free-trade as the preferred ethos, they have proven ineffective at creating a common economic environment in which corporations can engineer the same strategy to achieve their goals across geographical zones or markets.
This failure is due to the complex continuum of events taking place daily in the global arena that forces corporate leaders to include new factors in their strategy matrices.
A strategy matrix indicates how effectively a business entity can achieve profitability by juxtaposing such factors as store location, operating procedures, goods/services offered, pricing tactics, store atmosphere and customer services, and promotional methods.
New factors to be added to the mix are diverse and intricate; hence, an exhaustive analytical list cannot be within the purview of this paper. Some emerging trends relate to online marketing, higher government intervention, shareholder activism, military deals with domestic or foreign vendors, terrorism and war effects, and intellectual property theft.
Business leaders usually lump some of these issues in several corporate functions: risk management, government relations, regulatory, marketing, human resources, etc., and address them at higher echelons only when their magnitude dictates executive decision-making.
This approach is erroneous because it fails to recognize the systemic pedigree of corporate strategy and the notion that it must include all risks and objectives across the organization to be successful. The threats cited earlier are complex and diverse, and they usually change market equilibria by permitting, for instance, small firms to compete against larger rivals in markets they once couldn’t have penetrated.
This is the reason why I ascribe the concept of “competitive asymmetry” to this new phenomenon.
Numerous news headlines illustrate competitive asymmetry in the market. Western luxury brands are nowadays faced with fierce competition from “made in China” faked items, while American pharmaceutical mammoths like Pfizer and Johnson & Johnson observe powerlessly patent-protected pills being fraudulently transformed into generics in India. Another example is activist investor Carl Icahn confronting Time Warner’s management and demanding a change in corporate strategy or organizational structure (segment divestiture, merger, acquisition, etc.).
Other instances include Boeing filing a contract protest with the US Government Accountability Office after it lost a military deal to Northrop Grumman Corp and Europe’s EADS or fast-food giant McDonald losing an eight-year trademark battle to stop Malaysian Indian McCurry Restaurant from using the “Mc” trademark.
These trends are obviously deleterious for most firms within the western hemisphere because that asymmetric rivalry deprives them of the profits their R&D investment must have normally secured over a large time span. The threat is coming principally from emerging and underdeveloped countries because now mature European, American and Japanese markets no longer offer maximal growth prospects and enjoy a legal environment that disincentivizes intellectual property malpractice.
Major companies cannot underestimate the criticality of these emerging trends because they not only stand to lose market share at home but also see their profits eroded in those international markets where growth rates are healthier.
I’ll end with some geoeconomics questions: how will Google’s recent infuriation at China affect the firm’s country strategy given that the current 300 million Chinese computer users constitute a less ignorable niche? What about its overall Asia strategy? Will business prevail over politics? Will Google’s potential exit from the Chinese market propel rival Baidu to domestic and global supremacy? How will that affect the firm strategy with respect to launching other products in a country with 1.3 billion customers? How will this affect Google’s overall profit line?
Rethinking corporate risk
A new risk typology is gradually decimating firm profitability amidst the ongoing economic crisis. Even though individual risks taken separately can be handled with a relative effectiveness, different risk management paradigms need be implemented to curb their cumulative adverse impact.
by Marquis Codjia
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An important staple in corporate affairs management lies not only in the intricacies of the external environment and its potential impacts – deleterious or favorable – on firm profitability but also in factors endogenous to the entity. A business entity has to panoramically gauge in permanence all elements that are part of its ‘quality chain’, that is, its supply chain and distribution channels taken in conjunction with its corporate brand rating within the market.
Uncertainty is at the heart of every business venture. The adventure of a venture is what epitomizes every undertaking that has profit seeking as its core ethos. Decision-makers are keen not only to seek the best ingredients for strategic success but to derive systemically the most cost-efficient modus operandi that will perennially heighten overall financial competitiveness and shareholder value.
Uncertainty can be viewed as the inherent dichotomy that exists in day-to-day decisions regarding core utility and chance; in other words, uncertainty is the big question mark that hangs on the shoulders of most corporate executives, asking them whether they’re making good decisions and whether these decisions will yield good outcomes.
Good outcomes are vital to immediate, short-term firm success in the marketplace; however, good decisions are preeminent in the long-run strategic standing of most corporations because a framework that structurally fosters the emergence of the best ideas and the most efficient and effective procedures uniquely positions these entities for a relatively perennial competitive dominance.
The current risk literature emphasizes that risk, that is, the unknown from uncertainty, can be construed in two ways: aleatory and epistemic. Aleatory risk refers to a situation of pure chance whereas epistemic risk is a conflict circumstance where the resolution depends on the experience level of the decision-maker and their judgment. The latter risk is customarily encountered in business dealings but the former is more a product of probability. For instance, Tony Merna and Faisal F. Al-Thani (2008, page 14) qualified the discovery of Viagra as aleatory because the drug was originally for angina but was found during clinical trials that it could be used to prevent erectile dysfunction syndromes in males.
Corporate risk officers need to continually devise a structured framework to systemically address risk at all levels of the strategic continuum, be it at the executive and project levels or lower echelons. Uncertainty is an indissoluble nexus in business; therefore, risk can never be integrally eradicated. This heightens considerably the criticality of a sound mode of operation that places due interest on the detection, the analysis and the mitigation of all risks across the firm.
Diverse risks but a single risk management framework
(Risk chart courtesy Astral Computing, Inc.)
Many types of risk are found in business entities nowadays, both exogenously and endogenously, depending on the economic sector, the market situation and position (monopoly vs. oligopoly, monopsony vs. oligopsony, or perfect competition) and the strategic direction corporate executives are disposed to spearhead.
To a majority of corporate leaders, the conventional risk typology addresses three key areas which are quintessential to business processes, firm profitability and monetary viability: operational, market and credit. These risk areas were redefined and enhanced through the Basel II banking regulation although the precepts of the latter regulatory corpus can be applied effectively to any business sector.
Operational risk lies in the execution of a company’s business functions and thus covers an incredibly large span of functions, from internal processes to human resources and IT systems. An example of such risk may be a theft of information or a loss due to internal fraud (asset misappropriation).
Credit risk refers to the unfavorable event when a debtor is unable to repay a loan or other line of credit due to bankruptcy or temporary liquidity problems (the epithet “country risk” is preferred when the defaulting party is a country or any other sovereign entity).
Market risk is the risk that market factors (stock prices, interest rates, foreign exchange rates, and commodity prices) may have individually or communally an unfavorable pecuniary effect on a corporate investment or trading portfolio.
Another risk – political risk – is present within a firm’s external environment and emerges concomitantly with a move into the international sphere. This relates to the financial peril that a country may suddenly change its policies and explains, in part, why many underdeveloped countries lack foreign direct investment.
Managing new types of risks
Admitting that risks are inherently the Achilles’ heel in most corporate functions makes accordingly easier the argument that an effective risk management program is pivotal to avoiding potential financial losses or brand damage. Risk officers need to utilize an effective and efficient toolkit in order to detect, analyze and mitigate or eradicate potential risks at all levels of corporate strata, and risk modeling via computer simulation has proven relatively effectual at mapping organization “risk cloud”. Chapman and Ward (1997, page 169) also identify more exhaustively eight phases in the risk management process: define, focus, identify, structure, ownership, estimate, evaluate and plan.
There exists at the moment a complex panoply of methods and systems to address risks, and that list is correlatively associated with the magnitude of the underlying events when they occur (high, medium, low). It can also be affected by the extent to which the probability of the likelihood of occurrence of such events cannot be evaluated with a comfortable degree of accuracy (Lifson and Shaifer, 1982, page 133)
New types of preeminent risks have surfaced the past few years in the marketplace, and at the moment these areas of uncertainty are eerily ignored or underrated by risk specialists or academic experts. Although some of these threats have been tracked with a fluctuating degree of thoroughness over the years, their stratospheric increase in the last decade and the resulting financial havoc on corporate cash accounts have catapulted them into the “high risk” category.
These risks are shareholder activism risk, reputational risk, and regulatory risk.
Tony Merna and Faisal F. Al-Thani still posit that the entire risk universe can be divided into 3 sections: known risks, unknown risks, and unknown unknowns. The latter category is of preeminent import in the current analysis because it encompasses the emerging threats named earlier.
Shareholder activism, an erstwhile epiphenomenon, has metastasized lately into a increasingly frequent and potentially deleterious incident within the economic landscape. Of course, the nuisance here is gauged from the vantage point of a corporate executive whose position or policies can be potentially annulled by outside activists.
This type of activism utilizes the conduit of equity stake in a corporation to put pressure on its management and reach the goals and strategies at the core of activist shareholders’ mission. Although shareholder value creation is one momentous ethos for corporate leaders, shareholder activists do not necessarily pursue a community of interests with other shareholders or business leaders. The dichotomy arises because the former group customarily seek short-term goals that are of utmost importance only to them and usually of a pecuniary nature, while the latter aspire to longer-term strategic goals that will enhance firm market standing and competitive status.
Magnifying investor activism risk is the economic observation that it is relatively cheap from the investor’s standpoint – a small ownership of 5 – 10% is sufficient to launch a fruitful campaign – compared to other more costly takeover undertakings within the economic sphere. In practice, stockholder activism can be found in several circumstances: proxy battles, publicity campaigns, shareholder resolutions, litigation, and negotiations with management.
Carl Icahn and T. Boone Pickens, both billionaire US investors, have proven very adept at successfully bringing about change within their target companies and in that process amass gargantuan profits once the desired restructuring, merger or takeover is completed. Mr. Icahn has parlayed his unique business acumen, strategic thinking and huge checkbook into The Icahn Report, an effective pedagogic resource that fosters his views on governance and economic matters.
From a corporate perspective, risks of this category can be extremely prejudicial because a takeover or board turnover can beyond a shadow of a doubt derail the medium- to long-term goals that managers set, which in turn can affect profitability and market leadership while costing the firm unnecessarily millions of dollars in litigation and public relations campaigns.
Reputational risk arises when adverse events affect the brand or social standing and image of a business concern as a result of actions undertaken by the media, firm employees, senior management, and government bodies or industry overseers (the latter group is the source of regulatory risk).
Corporate managers need to heed the aforementioned new risks in a different manner than ordinary risks due to their intense asymmetry (low cost vs. sizeable financial damage). Obviously they must apply the best practices dogma of good financial decision making in corporate finance to this risk typology: present value, financial statement analysis, and risk and return but also option pricing and governance code (Damodaran 2006).
In addition to a solid IT infrastructure aimed at capturing these risks, corporations need to create a new consolidated function, working under the aegis of the Chief Risk Officer, to synergistically address these areas of uncertainty. This role must have overall responsibility for the development and implementation of a detailed business risk management framework and advise senior leaders on sound corporate governance practices. The future of solid firm profitability is at stake.
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