Expert View: Frescobaldi, the markets need you

Finance is an ancient profession. Most of the tools used by modern investment bankers were invented in Italy in the 14th century, if not before. Balance sheets, profit and loss accounts, return on capital: the Renaissance bred innovation in capitalism as much as in the arts. One such source of ideas was the House of Frescobaldi, which became the major financiers of the UK government, at a time of escalating government spending. It was the subsequent default by HMG that sent it into bankruptcy (supporters of Gordon Brown, please note).

But these touchstones of capitalism are no longer safe. The conceptual framework created to capture financial performance is being seriously challenged by the current crisis. Investors have lost faith; iconoclasts abound.

Inevitably in our entrepreneurial culture, someone was bound one day to come up with the intellectual wheeze of "off balance sheet". What is surprising is that not until Enron was it done on so grand a scale. The creation of off-balance-sheet partnerships made financial information disclosed to shareholders almost meaningless. Post-Enron, investors are seeking new tools to ana-lyse corporate liabilities.

The Nineties boom led analysts into equally dangerous territory. The focus shifted from company earnings (as measured by EPS) to Ebitda (earnings before interest, tax and depreciation). This new false god was seen as a way to capture the fledgling dot-com industry's true performance. It proved instead to be an exuberance gauge. Now, Ebitda is ridiculed as "earnings before anything", and investors are left holding hollow, cashless companies.

The sanctity of the profit and loss account has not been helped by the exclusion of stock options granted to company executives. As the great investor Warren Buffett, the sage of Omaha, puts it: if options are not a form of compensation, then what are they? If compensation is not an expense to the company, then what is it? And if company expenses are not put through the profit and loss account, then where should they be put?

Goodbye to balance sheets, goodbye to P&L – the demolition of the twin pillars of capitalism is to no small extent what has caused the current crisis. But while discarding ancient shibboleths that can help us, we are sticking to more recent concepts that don't.

The vast majority of the UK's stock market is owned either by insurance companies or by UK pension funds. Both groups are seeking to match future liabilities by investing wisely. It is difficult enough to quantify the scale of future liabilities (a relatively modern art going back barely 200 years for insurance companies, and less than 100 for pension funds). But the real rub is in the attempt to predict the future return on assets that will one day match these liabilities, a task that is in the hands of the actuaries, who've been doing it for mere decades.

The problem is that in the current highly depressed markets, the formulae used appear to make insurance and pension funds virtually insolvent. Investors are pushed away from equities towards bonds, arguably at the very moment of least relative value. Worse, the consequent selling by these major institutions of equities (to buy bonds) pushes the market even lower, which makes the problem even worse, which makes them sell even more, and so on.

The good news about the current crisis is that so far it has had very little effect in the "real world". Economic growth has slowed, but we are a long way from a traditional recession with a significant contraction in economic activity. However, if we are not careful, some of these conceptual posturings will start to have real effect. It's time for some lateral thinking. Are there any Renaissance men in this market?