“Systemic risk” is a concept which has come to the forefront in the past couple of years as people have searched for the cause of the financial crisis. Post-mortems have focused on the unbelievable level of risk taken on by institutions and the speed with which it was transmitted to others when conditions started to sour. Contrary to theory diversification, rather than mitigating risk, actually contributed to the contagion and amplified the damage. The broader consequences of the crisis have been far too familiar for the past three years and they could have been prevented if regulators were vigilant for the right signs. A similar level of regulatory passiveness currently exists in the soccer economy and it is encouraging the rise of financial risks that pose a serious threat to clubs and their supporters.
What is systemic risk?
Systemic risk refers to the level of dependency of a system on the vitality of any individual piece. As an example, any single card represents a high systemic risk to a house of cards, whereas one brick represents a low systemic risk to a wall. AIG was one of those cards. In September 2008 the insurance giant brought the international financial system to its knees as revelations came to light about the billions of dollars of credit default swaps, insurance on securities, it had sold came to light. The mortgage securities it insured were quickly dropping in value and there was no chance of being able to honor any payouts on the swaps. In the end the Federal Reserve bailed out the insurer, judging its default to be an unacceptable risk to the financial system.
Risk is created whenever one institution creates a financial obligation with another party in the system. In an ideal system there is no increase in risk: someone’s liability is someone’s asset, interest is paid to compensate for the risk and the principal is returned at maturity. In reality, both internal and external shocks may cause a counterparty to lose the ability to repay a debt and an asset can quickly become worthless and erasing value from the economy. ‘Systemic’ risk comes into play when institutions have a high degree of interlinkage such that the health of one invariably affects the health of another. The greater the amount of leverage, the greater the level of risk in the system. The more interconnected institutions are the more likely a highly leveraged economy is to suffer a systemic crisis.
Is there systemic risk in the soccer economy? Undoubtedly. Is there a club that could be an AIG-like domino? Probably not, but the possibility is growing. Both the deterioration of club balance sheets and the increasing use of structured payment mechanisms in player transfers are providing the conditions needed for a substantial increase in risk.
The growth of debt levels has been driven primarily by transfers and wages. Player related costs are the single largest recurring expenditure for soccer clubs and continue to grow proportionally with revenue (and have a large impact on club valuation despite what Forbes may say). Structured player transfers typically involve spreading out or deferring payments completely to make a player more affordable for a buying club. These transactions are alluring for both sides as buyers part with less cash in the short term and sellers book larger transfer revenues than would have been achieved in a cash-only environment. It is an apparent win-win scenario, but in actuality it is balanced out by the risk introduced into the economy, the cost of which remains unseen until things go wrong.
In addition to vanilla deferred payments structured deals can contain conditional clauses which trigger additional payments based on the fulfillment of certain criteria. Some examples of this are a fee paid to the selling club if the player participates in a certain number of matches or a percentage of the profit from the next sale of the player. Though the clauses sound relatively innocuous they are actually derivatives on player registrations written by the buyers. While they do not hold the same destructive potential as derivatives in financial markets, they do represent a conditional liability which affects the financial standing, sometimes significantly so, of a club.
By using structured transfers selling clubs inadvertently transform themselves into mini-banks and become lenders of credit to buying clubs. If a buyer defaults on payment the seller suffers from a cash flow crunch in the best case and suffers a loss on an asset in the worst. Smaller clubs will be disproportionately affected in the case of a liquidity shakeout because they are more likely to employ structured deals and are more dependent on transfer revenues for cash flow compared to larger clubs. In short a bust would be disastrous for all but the top levels of the soccer pyramid.
What to do?
Nobody has a handle on the level of risk in the soccer economy. The question “What clubs would be affected by a Manchester United bankruptcy?” would likely be met by blank stares in many board rooms. The chief cause of this is the lack of transparency in the transfer market. Without information about the financial details of transfers there is no chance of understanding the interdependence of clubs and the level of risk in the soccer economy. It does not have to be this way.
Action on this issue should begin at the national level, after all FAs have the most to benefit from understanding the risk of their soccer leagues. The English FA in particular should take a leadership position on this issue as the size and depth of the English soccer market makes it both influential and critical to the rest of the soccer economy. All sanctioned clubs should be required to provide detailed information on transfer activity, including gross fees paid, commissions paid, payment schedules and contingent clauses, all of which would be subsequently publicized. This would serve several purposes. First, it would force clubs to properly account for all outstanding player-related liabilities, something which some clubs do not seem to do even without such a system in place. Second, providing access to such information would allow clubs to more accurately gauge the credit risk of any clubs they might do business with. Third, it would allow the FA to begin to understand the web of financial connections between the clubs and the risk of any possible defaults. And finally, a transaction history would provide some basic guidance for player valuation in the incredibly opaque transfer market.
To continue to operate without some understanding of club interdependence is to encourage the further growth of systemic risk in the soccer world. This is not just governance for the sake of governance, the industry is a vital part of many national economies and disruption would pose a real threat to jobs and economic growth. It is time to be proactive and head off crises before they become unavoidable.