Economic View: If notional principles give way to harsh reality, we'll all feel the shock waves from South Sea Bubble accounting

There are steps we can take to protect ourselves against a recession, but the financial risks being run by the banks are outside our control
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The Independent Online

The business environment changes. The possible impact of a credit squeeze has had some attention in recent weeks. Some people say we must not talk ourselves into recession, but if we attempt to understand the risks and possibilities, then we can all make better decisions.

It is fairly obvious that mortgage lending is going to decline, which will have an effect on house prices. There have already been reports of banks restricting lending to consumers and businesses. Northern Rock's management may hope to rebuild their business, but any penalty costs will result in higher charges to borrowers, causing the good risks to remortgage elsewhere. As all lenders facing such cutbacks will know, business then shrinks and bad debts rise as a proportion of that business.

You can be sure that the central banks will react to any further signs of financial stress by cutting interest rates. A competitive round of interest rate cuts is now inevitable. Another risk is that the carry trade will reverse, and instead of propping sterling up, outward financial flows will drive it down. Money lost from sterling is money that cannot be lent. The combination of banks lending less and a war of lower interest rates means that credit will become scarce but cheap. This will be a major change in economic conditions, much as the disinflation that started in 1990 heralded a major change in the business environment.

There are other "wild card" risks. The China bubble may burst. The high level of private investor participation in Chinese stock markets is a warning sign. And a general air of nervousness will see capital projects scaled back just in case.

Clearly it is time to be selective about new business ventures. Businesses often find it hard to plan for recession but there are some obvious safeguards. Avoid taking on large recurring commitments; test every business plan for recessionary risk; beware of risk concentration; avoid marginal activities unless they contribute handsomely to revenues at little cost.

In recent years, there has been huge growth in "low-cost" activities: for example, budget airlines and the self-service economy in which consumers do more and more tasks in their own time. Luxury goods and services have prospered in the general credit expansion, even though luxuries generally look vulnerable to cutbacks in spending. The middle ground, squeezed by the self-service economy on one hand and ever-increasing regulatory impositions on the other, will also be under pressure.

The financial system is not a separate world. What goes on in capital markets affects everyone. While we can hope the China bubble will stay inflated, and that banks will soon be lending again, we must consider the risk of further financial fallout. Here, derivatives are the key.

In the very early stages of this summer's upset, Merrill Lynch tried to sell some $800m (£400m) of derivative assets in the investment bank Bear Stearns, but apparently reduced the scope of the sale as prices fell. Bear Stearns then rescued a fund with its own money – and weeks later, markets were paralysed by the contagious fear of loss.

Most lending banks now hold derivative assets and liabilities. The values are disclosed on their balance sheets and the valuation basis is explained in notes to the accounts. The authorities in effect rely on value-at-risk computer models to manage banking capital, since there is little trading activity that could establish a true market. When hedge funds took price hits on their own derivative holdings, the explanation was that this was a once-in-a-million-years event the model could not foresee. However, the mathematical flaw in all these models has been eloquently explained in a recent book, The Black Swan by Nassim Nicholas Taleb.

What if the lack of an active, liquid market should prove more widespread? Then the "fair values" of the models may be found wanting. When the pressure comes on, stock has to be sold cheaply; assets tend to be worth less than you think and yet liabilities somehow turn out greater than expected. This aspect of the credit crunch has had no attention at all.

A quick look at Northern Rock's December 2006 accounts sheds some light on these broader financial risks. The Rock discloses derivative assets of £871.3m and derivative liabilities of £2.392bn, compared to shareholders' equity at £3.21bn and total assets of £101bn. The "fair value" of derivatives may seem beguilingly low, but the risk, particularly on the liability side, can be much higher. Accounting standards require disclosure of the notional principal amounts. At Northern Rock, the notional principal of all derivatives is noted as £111.44bn, slightly more than total assets.

So this is the real financial risk that may affect your business future. The total notional principal of all financial derivatives may now be between six and 10 times world GDP. It would be nice to think the authorities have a plan to manage this and perhaps limit any further growth in obscure financial instruments that few understand. The historical example is there for all to see. As the South Sea bubble burst in July 1720, one of the companies involved was abolished by Order in Council "for carrying on an undertaking of great advantage, but nobody to know what it is".

David Kauders is senior partner of Kauders Portfolio Management