riskupdate Risk Reward 35COMPENDIUM Update Q2 2009- The... · Union Bancaire Privee. Fauchier Partners manages USD 4.3bn in hedge fund investments and inherited a USD 30m position

riskupdate 35

CO

MP

EN

DIU

MQ

3 2

00

6 –

Q3

20

09

The quarterly independent risk review for banks and financial institutions worldwide

Risk Reward

© Risk Reward Ltd UK. All rights reserved. Available by subscription only – not for sale or resale

CompendiumRisk Updates September 2006 – August 2009

Risk Update Compendium

20

06

20

07

20

08

20

09

Over the past three years Risk Reward has been publishing theonly truly independent global Risk Update, focusing on thefinancial crisis and critical risk issues as they arise. Our viewshave effectively tracked the development of the global creditquake and, for our subscribers to date, have provided them withthe strategic, practical and technical guidance that they requiredto steer through these choppy global waters.

Who has been reading the Risk Updates? May we share anenlightening story?

The Risk Updates have been available by free subscription. Onthe Risk Reward website there is a field whereby the reader isinvited to subscribe to our Risk Reward Risk Update, producedquarterly and emailed to the address provided in PDF format. Wedo not know who the subscribers are, or their organisations. Lastyear we had a temporary secretary come in to send the emails andshe inadvertently sent over 500 subscriber emails without theRisk Update pdf attachment.

We only discovered the error when over the following few dayswe received hundreds of emails saying –oops – please resend withthe attachment... At this point we were now able to see whosome of our subscribers were from their auto-signatures in theiremail to us: Bank Chief Executives, Heads of Risk Management,Heads of Compliance, Chief Internal Auditors, Audit Managers,Lawyers, Big Four accountants and more from all over the world.Today the subscribers list exceeds 1500 and increases daily.

In this Risk Updates Compendium September 2006 – June2009 we have republished all of our previous updates in aconsolidated compendium so that they may be used as aconvenient reference tool by our subscribers and new readersalike. All of the articles are as they originally appeared and nosubsequent changes have been made.

We hope that you find this new publication of interest and lookforward to hearing from you with your feedback andrecommendations for future editions.

Best of luck in continuing to navigate the choppy waters of theglobal economy.

With best wishes

.Dennis Cox BSc, FSI, FCAChief Executive Officer

INDEX PAGE

RISK MANAGEMENT CASE OF THE QUARTER – AMARANTH 1IAS 39 – ACCOUNTING FOR FINANCIALINSTRUMENTS 2RISK REWARD PREDICTIONS 2007 2THE PROBLEM WITH ECONOMISTS 3THE BANANA SKINS SURVEY 3KEY UNCERTAINTIES IN 2007 4ARE THE CURRENT GLOBAL WARMING MODELS REAL? 4SCENARIO MODELLING 5CORPORATE FRAUD ASSISTED BY MANAGERS 5FUNDING SMALL BUSINESSES: THE 3 F’S RULE 6THE GLOBAL PROPERTY OUTLOOK: LOOK SOUTH AND EAST 6CURRENT MARKET TURBULANCE 7THE CHALLENGE OF MICRO FINANCE 8TOTAL RISK MANAGEMENT & BASEL 2 9THE PROBLEMS OF ZIMBABWE 10WHAT REALLY CAUSED THE SUB-PRIME CRISIS 11THE 2008 RISK REWARD PREDICTIONS 13THE FIASCO THAT WAS NORTHERN ROCK 14THE PROBLEM WITH REGULATION 15WHAT IS THE ROLE OF THE BANK OF ENGLAND & THE FINANCIAL SERVICES AUTHORITY (FSA)? 15WHY WERE THE SIGNS OF PROBLEMS IN THE BANKING SECTOR IGNORED? 16CAN YOUR RISK SOLUTIONS COPE WITH CHANGE? 17WHAT IS HAPPENING IN THE COMMODITIES MARKETS? 18THE PROBLEMS OF ACCOUNTING STANDARDS 20THE NEED FOR ACCOUNTING TRAINING 20THE CREDIT QUAKE: WHAT SHOULD OR SHOULD NOT BE DONE NOW? 21RISK MANAGING THE ELEPHANT IN THE ROOM 24WHAT NEXT FOR RISK MANAGEMENT? 25THE RISK REWARD 2009 PREDICTIONS 25PONZI SCHEMES 26FREQUENTLY ASKED QUESTIONS 27THE PROBLEM WITH RATING AGENCIES 28THE G20 RESPONSE - THE FUTURE OF FINANCIAL SERVICES REGULATION 29NEW HIGH LEVEL PRINCIPLES FOR RISK MANAGEMENT 31ASSET MANAGEMENT SOLUTIONS: FOR THOSE LEFT HOLDING THE (MONEY) BAG 32THE TURNER REPORT REVIEWED –THE FSA’S RESPONSE TO THE CREDIT CRISIS 33INVESTMENT STRATEGY IN THE CURRENT ENVIRONMENT 35CO-SOURCING OR THE NEW WAY TO ENSURE AUDIT EXCELLENCE 38STRESS TESTING PRACTICES AND SUPERVISION 39ISLAMIC FINANCE 41BASEL SETS THE STANDARD...IS YOUR BANK INTERNAL AUDIT FUNCTION UP TO IT? 43THE BIAS RATIO – CAN FRAUD BE MODELLED? 44CROSS BORDER TRADING 48WHERE IS REGULATION REALLY GOING? 49

Undoubtedly the most important casethis quarter is the collapse ofAmaranth, a hedge fund. In a scenarioreminiscent of the failure of Long TermCapital Management, AmaranthAdvisers managed to lose USD 6.4bnof investors’ funds.

What are the key lessons and whatwent wrong? At the heart of theproblem is that hedge funds tend tooperate technical models on whichthey base their trading activity and bydoing so they are trying to seek outenhanced returns for their investors.These investors should recognise thatenhanced returns must always come ata price, which is an enhanced risk ofloss. However they may easily take theview that whilst they can only lose100% of their investment, they do havethe opportunity of winning returns inexcess of 1000% if things go really well.

Remember that most hedge funds arenot regulated and that most modelsmake simplifying assumptions to enablesolutions to be identified and takenadvantage of in the market.

Typical assumptions made in suchtrading environments may include thefollowing:

1. That all markets are equally andinfinitely liquid

2. That every transaction would findan arms length intelligentcounterparty

3. That markets are rational andnormal

4. That external events can be ignored5. That counterparty credit risk can

also be ignored

These simplifying assumptions enablecomplex mathematics to identifyopportunities in the market for thehedge fund to exploit. Ofcourse every time youimplement a model basedupon any form of assumption,if that assumption becomesinvalid it impacts theaccuracy of the model andthe trading strategy adoptedwill be sub optimal.

In the case of Amaranth thelist of groups investing clientmoney included GoldmanSachs, Deutsche Bank, ManGroup, Credit Suisse andUnion Bancaire Privee.

Fauchier Partners manages USD 4.3bnin hedge fund investments andinherited a USD 30m position inAmaranth. In a letter to their investorsthey identified the shortcomings atAmaranth as being:

Apparent absence of sufficient riskcontrols:■ High leverage■ Poor transparency■ Performance heavily dominated by

one strategy■ Uncapped expenses in addition to

management and performance fees■ Annual reset of high watermark on

performance fees

■ Self-administration, so no externalparty was verifying returns

■ In-house broker dealer, making itpossible to smooth returns

■ Individual traders who were notinvesting in their own books

■ Poor liquidity terms

As a result of this Fauchier disinvestedfrom Amaranth in December 2005,foreseeing problems ahead.

At the heart of the issue is the level ofdue diligence that is conducted onhedge funds by financial institutions.Fauchier clearly believes that this wasinadequate and that by implicationother similar events will occur. WellAmaranth is the second big lossfollowing LTCM, so another failurenext year is probable. The problempurely is working out which fund wouldbe the one to fail!

Source: The Times (London) 13 October 2006.

RISK MANAGEMENT CASE OF THE QUARTER –AMARANTH

Risk Update 2006 – Q3

At the heart of the problem is thathedge funds tend to operatetechnical models on which theybase their trading activity and bydoing so they are trying to seek outenhanced returns for their investors

1

The development of international accounting standards issomething that we generally welcome. It will enable accountsto be prepared globally on a set of consistent and wellunderstood accounting policies, facilitating globalunderstanding of risk and performance.

Generally this is all well and good – and then there is IAS39… Accounting for derivatives has long been a subject ofconcern. Should they be on balance sheet or off balancesheet? Should the change in value go through profit or loss orbe taken to equity?

IAS 39 has tried to address this, but in so doing hasdeveloped an arcane set of rules that are difficult toimplement, could be abused and result in disclosures that arealmost impossible to understand.

The basic idea underpinning the rules is that if a transactionhas been entered into to hedge the equity of the company,then any resulting gain or loss should really go to equity. Formost of the rest it should go the profit and loss and you needto have some rules to deal with changes between the two andthe additional disclosure of the reason for the change.

There we have it – in one paragraph we have managed tocome up with what would be a simple and easy apply basicproposition with everything else becoming an example.

IAS 39 takes the opposite approach. By trying to covereverything and therefore moving away from commonlanguage usage, the standard becomes hard to understand andsometimes appears rather odd. Firstly you have to designatetransactions as being fair value through profit or loss. Fairvalue is effectively either mark to market or mark to modelalthough there is more guidance on this. This is a formaldesignation of intention.

Secondly, hedges need to be formally designated as such, withdocumentation identified and the specific assets set out.

Amongst the hardest to use rules are those on risk and rewardand control (in that order). If an institution has managed totransfer the majority of the risks and rewards of a financialasset to a third party, then the asset is derecognised. Thatmeans it becomes off balance sheet with an explanation of theremaining risks. Likewise if the majority of the control of theasset is transferred, even though it still has the risks andrewards, then again the asset is derecognised and disclosed.So what is material?

The market appears to be in two camps. One says that thereis an 80-120 rule with the other taking the 90-110 approach.That means that identical firms in identical situations willactually treat identical assets differently. This is purely one ofmany concerns we have over this particular standard, whichwe would contrast to IAS 21 (foreign currency) which is botheasy to understand and simple to implement.

As an accountant one does despair sometimes at the way thatwe make things increasingly difficult. Creating complicatedrules that are difficult to implement and impossible tounderstand can hardly make any sense, so we hope that IAS39 is reviewed and amended in the near future.

In common with everyone else we will give our predictionsfor the year ahead. All of these are the estimates that oureconomic team have come up with on the basis of theirview of the markets. Whether they will be right or wrong,we will see next year! Use them with care – all estimates arereally worth little more than the electronic media theyare written on.

Global EquitiesOur view is that the global equity market will continue togrow over the year, although there will be significantindividual variations between areas. A general growth ofbetween 5% and 10% can be expected. In these terms weare probably less bullish than many of our peers.

UK EquitiesAs a UK based firm the UK markets are always close to ourthoughts. There are a variety of issues that could cause adrag on the UK market, but these have been counteractedby a pull caused through the impact of investment housestaking listed companies private. Our expectation is that themarket will grow by 15% over the year.

US EquitiesIn comparison we are increasingly concerned at the state ofthe US economy. The slow deindustrialisation of the USwill continue to be a drag on both the market andcurrencies. Our expectation is that the US will underperform global markets with growth of between 3% and5%.

Middle East EquitiesThe Middle East markets have had a torrid time in 2006.With regret we do not expect a major bounce in 2007. Ourexpectation is that the markets will on balance recover alittle – but only by around 5%.

UK Property MarketUK residential property still appears to be growing and thelack of adequate supply continues to ensure that a demandled pull will continue. Our expectation is an overall increaseof 12% - 17%, with Outer London rates being perhaps 5%higher. This level of optimism does not carry tocommercial property where we continue to have concernsand anticipate a reduction of perhaps 5%.

US Property MarketThis is a greater concern than the UK markets. Weanticipate reductions in both the residential market (5%)and commercial markets (10%).

Interest RatesOur view is that UK interest rates are artificially high. Wefail to understand the approach taken – to try to reduceinflation caused by movements in commodity prices bymoving interest rates. However on balance we expect ratesto be much the same at the end of the year to thebeginning of the year.

The US DollarWe anticipate that the US dollar will continue to be underpressure and will fall further during the year.

IAS 39 – ACCOUNTINGFOR FINANCIALINSTRUMENTS

RISK REWARDPREDICTIONS2007


2

At this writing the Bank of Englandhas surprised the market andincreased interest rates by 0.25% to5.25%. In itself this may not seemdramatic, but it is a symptom of theapplication of illogical thinkingwhich remains a concern.

The Bank of England have a keyresponsibility to ensure that inflationkeeps below 3%. To achieve this theyonly have one measure available tothem – moving interest rates. Theybelieve that increasing interest rateswill take consumption out of theeconomy and therefore will reduceinflation.

This would be a valid argument if therewas any evidence that this actuallyworked in practice. From Risk Reward’spoint of view we see there as beinglittle or no real inflationary pressure inthe economy. We see the recentincreases in the government’s figures as

reflecting four main things-

■ The last increase in interest rateseventually working through

■ The increases in indirect taxationworking through

■ The historic increases in oil pricesappearing within costing

■ Increases in the price ofgas and electricity

This is counteracted by aweak retail and wholesalemarket which is keeping a lidon real price increases. Ofcourse oil prices havesubsided and this in itselfresult in lower prices nextquarter. Yes there has also been anotherincrease in house prices, but this leadsto greater dynamism in the economyand an improved opportunity forgrowth. Increasing interest ratesensures that growing companies arekept under pressure through increasing

costs, whilst increasing the inflationarypressure on wage demands and alsocausing strengthening of the currency.Not a palatable proposition. Had webeen able to vote we would probablyhave reduced interest rates to 4.5%.

What would the effect of that havebeen? The currency would haveweakened, improving globalcompetitiveness and reducing the costsof imports. Inflation would thereforereduce and the economy would grow –surely a virtuous circle.

THE PROBLEM WITH ECONOMISTS

The Centre for the Study ofFinancial Innovation publishes anannual report which sets out theissues which are of greatest concernto the management of financialinstitutions, entitled the BananaSkins report.

This report is based on responses fromthe leading financial institutionsglobally and always makes interestingreading.

In 2006 the Top 5 Responses were asfollows (2005 in brackets)

1. Too much regulation (1)2. Credit risk (2)3. Derivatives (4)4. Commodities (14)5. Interest rates (12)

The rate of change of regulation is achallenge for any institution, with muchregulation not being valued by the endcustomer who eventually pays the billfor such work. The difficulty ofensuring compliance is resulting inmany firms diverting their attentionfrom risk based issues to looking atnarrow compliance issues where thereis limited value to be gained. Of coursethis is a key concern for management –they wish to run efficient businesses

that comply with relevant guidance.However good banks try to comply,whilst the rogues will claim they docomply ... quite a difference.

Credit risk is a key risk in this marketparticularly due to the impact oninterest rates rises (issue 5). This islikely to result in increased bad debtswithin financial institutions, although inour opinion the actual level of risk hasbeen overplayed and such problemsmay well be short term. We do expectcredit risk to still be No. 2 next year.

Derivatives have increased theirranking to No. 3. Risk Reward does notsee derivatives as by nature high riskinstruments, but the increasing use ofthem in new areas (credit derivatives,property derivatives) has probablyresulted in this increase.

The level of risk that is moved aroundby derivatives is a cause for concernsince the failure of a majorcounterparty will impact a widerange of institutions.

In our opinion we should put all of theglobal economists in one large room.…and leave them there. The presence ofcommodities at No 4 is a surprise.Clearly the volatility of the oil price hasresulted in this inclusion, but we expectthe risk to diminish next year and theranking to be reduced. In terms ofinterest rates we are concerned that theglobal markets are making the samemistakes that were made before byincreasing interest rates at aninappropriate time. Will this result inanother round of really major rateincreases and another US rate spike atperhaps 18%? We clearly hope not, butthe concern does clearly exist.

THE BANANA SKINS SURVEY


“Put all of the global economists inone large room ... and leave themthere”

3

There are a range of matters that could cause majordisruption to international markets during 2007. Mostimportant and without any particular enthusiasm we arepredicting a major terrorist event during the first half of 2007which will cause financial disruption. Our concern is that thismay involve a high level political assassination or an attack ona major international airport and its infrastructure.

Major environmental concerns are also more likely than not,but we do not believe that these will have a major economicglobal impact.

US economic policy remains a concern. If the US repeatsprevious mistakes and over compensates on interest ratesthen the US could fall into recession in Q3 2007. This wouldbe a burden on the US consumer and the global economy,potentially causing a global slowdown. This will be felthardest in growing economies increasingly dependent uponthe US consumer , such as China and India, for their growth.

We do anticipate a major financial failure during 2007 causedby impropriety - hardly a surprise since there is one in mostyears.

Many of you will have seen Al Gore’sworthy work entitled “An InconvenientTruth” which looks at changes in theglobal environment and indirectlyconcludes that the hand of man is atwork in potentially ruining the planet.The conclusion is that something mustbe done.

Risk Reward is not a political companyby any possible connotation, so ourviews are not biased by either industrialor political aspirations. By nature welean towards a chartist approach toissues, but this is perhaps our only bias.

When looking at changes to the globalenvironment, we take a broader view.We look as to whether there are anyforms of historic parallel to what isoccurring and are there any alternativebut plausible scenarios. ScientificAmerican recently published an articleon the factual variation of the earth’saxis. Such variations are both certainand predictable and have major impactsupon environment. Are these thecauses of the short run climate changesthat we are seeing at present? We haveno idea, but suddenly the issue is not asclear cut. It is not possible to separatethe impact on our environment of achange in tilt of the axis of the earth,from the creation of pollutants. What isclear is that the impact of the change inaxis is likely to be dramatic in terms ofglobal impact with areas currentlycovered by ice and deserts becomingverdant forest, whilst other areas willrun out of water or be covered by ice.We call this an inconvenient fact.

In the past the earth has had ice agesand periods of global warmth,apparently with the heating occurringbefore the ice age. Indeed the global

warming is seen by some as being theprecursor to the ice age. You do haveto recognise that we have haddinosaurs and mammoths which havedisappeared without the impact of asingle petrol engine.

We do a lot of work in the Middle East.Here there is clear evidence of globalcooling – basically the desert is gettingcooler. Having suffered unseasonablycold weather in Dubai andtemperatures of no more than threedegrees in Bahrain, whilst the orangecrop is wrecked by frost in California,it becomes clear that global warming isnot a global phenomenon, but perhapsmore of a Western construct.

The ices flows are melting, yet gettingthicker in the centre… Something ishappening, but is it the next ice ageand if so what might happen?

The likely scenario appears to be thatthe pole moves over to the USA with

New York disappearing under a sheetof ice. Northern Europe becomestropical, Southern Europe desert andthe Middle East forest. Does all thatseem rather far fetched? Consider thatwithout vegetation of some form youwould never had any oil!

The most likely scenario that we see isthat the effect of so much carbondioxide and other pollutants mightactually be to delay the forthcoming iceage – so perhaps we should all pollute!Yes there will be movements in globaloccupation patterns, but there is againnothing new in that.

Clearly the Gorian analysis is weak—you cannot just take one hypothesisand apply it without looking at thetotality of all alternatives.

Mind you, this is being written on aplane and of course Risk Reward doeshave a large carbon footprint.

KEY UNCERTAINTIES IN 2007


ARE THE CURRENT GLOBALWARMING MODELS REAL?

4

For banks scenario modelling isrequired for any institution intendingto follow the AdvancedMeasurement Approach of the BaselAccord. The intention is clear: todesign a series of plausible scenariosto be applied throughout a firmmaking use of both external data andmanagement knowledge.

The technique is to look at an externalevent, identify generic issues thatcontributed to the loss, then interpretthem in a way that creates a plausiblescenario applicable to your firm. Youthen work out the expected loss andthe likelihood that such a loss wouldoccur. Simple?

Not really, since there is still a lot ofmanagement interpretation requiredand management have not been trainedto anticipate potential but relatively

remote problems, rather they arerequired to focus on day to daymanagement of the business.

Such scenario analysis should be runquarterly and reassessedannually to ensure that thesescenarios actually remainappropriate.

The work is time consumingso probably no more than 25scenarios will actually beconstructed.

However the information thatresults from such scenario analysis isone of the most useful tools available tothe risk manager and also one of themost interesting reports provided to aBoard.

Barclays bank in their 2005 accounts

state that their worst possible loss is£14.1bn and that this might occur oncein five thousand years. Not sure whatthe management would do with thatpiece of information, but the objective

is clear in achieving a high level ofmanagement attention to events thathave not occurred rather than alwaysfocusing on events that have occurred.

Perhaps the event that are modelling isactually the next ice age.

SCENARIO MODELLINGGLOBAL WARMING NATURALLY LEADS TO SCENARIO MODELLING

Corporate fraud is one of the mosttime consuming and expensive mattersthat can confront a company. The realquestion is whether there is anythingthat should be done by management toprevent fraud.

The problem is of course a simple one,in that most fraud is actually committedeither by, or with the assistance ofmanagement.

Are there any warning signs that aboard need to be aware of—perhapsthere are…

1. Is there any employee or officerwho appears to be actingirrationally? If they appear to beacting irrationally in their privatelives and general corporate work,they also are likely to havedifferent ethical standards to thosegenerally expected.

2. Is there any employee or officerwho appears to be unduly

financially stressed? When anindividual is under financial stressthis can also impact on their ethicalstandards.

3. Is there an officer or employee thatappears to be forming businessrelationships that need to beratified in arrears? This wouldsuggest that they are not a teamplayer and not to be trusted.

4. Is there any employee or officerthat believes that they are owedsomething by the company, whenthis is not the case. This is anextremely dangerous individual tomaintain within the firm.

Of course matters are never clear cutand the person may not actuallyundertake a fraud. The employer isoften in a position in that if they applytoo much pressure then the employeeor officer could claim for unfairdismissal, or even worse, take actionsthat might cause them personal harm.

So what should be done? The answer isadditional vigilance over the activitiesof the individual concerned to ensurethat nothing inappropriate does takeplace.

This part of the newsletter has beenwritten with experience we are awareof, where an individual that appeared tobe a friend of the directors had turnedagainst them. The warning signs werethere for a year, yet the position of theofficer made acting against himdifficult. The risks were known, but itwas found to be difficult to come upwith an adequate response. Two courtcases later they wish they had.

CORPORATE FRAUD ASSISTEDBY MANAGERS


“Put all of the global economists inone large room ... and leave themthere”

5

We are returning to this subject again due to the number ofmicro finance requests that we receive. Many of these are inno way international by nature and are not of sufficient size to

enable a firm like RiskReward Limited to bedirectly involved.

That can mean thatthere is a problem. In arecent case we wereasked for advice bysomeone that wantedto buy out theirpartner in a business,which is operating

locally. On the assumption that the business is both tradingand profitable, the company may well be in a position to raiselocal finance. However, can an individual raise finance on thesame terms and with the same likelihood?

The individual has the following assets.1. The share holding that they currently own.2. An expected income stream from the company (salary or

dividend)3. Other personal assets (property etc)

In principal any of these can be used to enable the individualto borrow funds to acquire the securities held by the thirdparty. In terms of the way that these are viewed by the banks,the highest quality asset is the property. This could be used ascollateral to enable a loan to be raised which would also besecured on the equities to be purchased.

The current shareholding also has a value but borrowing canbe difficult since such unlisted securities are difficult to valuewith certainty. The costs of doing so would generally result init not being appropriate to take this route and the bank willreject the asset as a main source of security. The income flowis also clearly important and will provide the credit standingof the individual. This will improve the rate that the individualwill get rather than being the prime determinant of theprovision of the loan.

What then if the individual has no significant other assets? Iregret that in most cases the individual is looking for fundingfrom the 3 Fs- friends, family and fools. I am afraid it is tough.Particularly in the developing world where there is often ashortage of capital to lend within the financial system, thebanks will find it easier to decline than to take a difficultanalysis or decision. Not good news I am afraid, but realistic.

FUNDING SMALL BUSINESSES: THE 3 F’S RULE

There is clearly a change going on inthe property markets. Those that haveexperienced long term growth may notnecessarily be able to support the samegrowth going forward.

Generally in Western Europe and theUSA commercial property yields forprime clients are extremely low inhistoric terms. Basically the investor isno longer being paid for the risks thatthey are taking on. We are nowregularly being offered properties at adiscount to corporate bond rates whichwe are unable to offer to any investorsor purchasers. This is the reason thatmany of our regular property clientshave not heard from us for somemonths.

In terms of residential property we areexpecting an adjustment in the USA,although this will primarily occur in themain residential conurbations and ruralproperty will not be affected.

In the UK we anticipate property

prices will continue torise for the foreseeablefuture (which wenormally define asabout three years). Thisis due to the imbalanceof supply and demandexacerbated by theOlympic effect in theEast London Area.

The position in Asia isvery uncertain. Theequity price adjustmentin China in the last fewweeks will have adramatic effect on the property market.Historic parallels would again suggest aprice decline of perhaps 20%, althoughthis will reverse in the following threeto five years. Again, we shall have tosee.

So where does Risk Reward believethat value does exist? We consider thatdeveloping markets, particularly inEastern Europe and Africa can produce

extremely high yields and capitalgrowth. However before buying in anysuch market you need to fullyunderstand local land rights, the legalframework and any political risks thatmight occur.

Generally if you are looking to sourceor sell international property then it isalways worth contacting Risk RewardLimited’s property division.

THE GLOBAL PROPERTY OUTLOOK: LOOK SOUTH AND EAST


6

“..in most cases theindividual is looking forfunding from the 3Fs—Friends, family and fools”

The key risk event in the last quarterhas, as expected, emanated from theUnited States property market, and inparticular its impact on the sub-primelending market. We are seeing creditspreads increasing and stock marketsreducing as a consequence of this.Below is a one-year chart of the Dowindex from Bloomberg, whichhighlights the August marketturbulence.

One of the main victims has been theGoldman Sachs Group who wererequired to inject USD 2bn into one oftheir hedge funds after it lostsignificantly as a result of the marketturbulence. Goldman Sachs referred tothis as a “significant marketdislocation”. We would refer to this aseither the manifestation of a scenario ora stress event actually occurring.

Let us analyse a little further what isactually happening at present. The USproperty market for probably the firsttime in at least 50 years is experiencinga downturn. This in turn is puttingpressure on the sub-prime marketlenders who are experiencing a higherlevel of default. Generally this has ledto a loss of interest in the sub-primemarket and also on companies that aredependent upon that market for theirsuccess. Accordingly sub-primecorporate bonds cease to be anattractive option and a consequent selloff occurs.

Basically there is a general rule thatunder a stress event the followingoccurs:

■ There is a flight to quality awayfrom sub-prime assets

■ There is a move to cash and awayfrom securities

■ There is a move to commodities andaway from synthetics

■ Capital repatriates to its homemarket

Some markets become illiquid, whilstothers remain liquid. All of theseeffects are completely predictable.There have been a series of similarevents in the past – is it so long sinceLong Term Capital Management’sfailure? However some parts of themarket are more susceptible thanothers to such market movements.

Hedge funds depend for their successon the quality of their financial models.These models will identify a tradingstrategy, which they are able to followand, in principle, achieve success.However, any model will by its natureinclude a series of assumptions,common amongst which are thefollowing:

■ Markets are liquid■ There are no market discontinuities■ Liquidity is constant■ Markets are rational

Effectively this is almost taking anextrapolation approach to risk analysisand so long as these key assumptionsremain valid, then the strategy will beeffective. The problem is that when theassumptions cease to be valid, themodel becomes unreliable andsignificant losses will occur.

What appears to have happened in thiscase is that Goldman Sachs was tooslow to identify that they were enteringinto a environment which was likely toexacerbate the occurrence of a stressevent that would undermine themodelling.

Typically US houses have been usingmodels that have been tested overhistoric data sets. That is fine as far as itgoes, but there are a number of effectsthat actually mean that current marketswork differently to historic markets oftwenty or even ten years ago. Theseinclude the following:

■ The development of theinternet over effectively the lastten years provides informationfar faster to a broader groupthan was previously the case

■ The growth of day trading totake advantage of short termmovements

■ The growth of hedge funds tomultiply the impact ofmovements in the market

■ The growth of short sellingenabling a firm to make moneyas the market falls

■ The growth of quantitativetrading strategies creatingmomentum in the market.

What this should tell you is that you

cannot rely upon historic correlationsand market movements to adequatelypredict the impact of stress events.Instead a firm needs to develop a seriesof plausible stress events that should beassessed across theirinvestment andtrading strategies.

The only questionleft is to considerwhat is plausible. Is99% adequate? Thatmeans that one in ahundred movementswould be outside theparameters sets andwould result inpotentiallyunacceptable losses.How about 99.9% orone in a thousand losses? Is the fall inthe US property market actually a onein a thousand event? I would expect afirm to have a strategy which identifiesany event that actually is occurring butwas in the 95%+ likelihood to enableexisting trading strategies to beimmediately reassessed to ensure thatsignificant losses do not occur. Yes thiswill in itself result in the flight toquality being even more pronounced,but it will prevent the occurrence ofsuch unacceptable losses.

Was this event therefore predictable?Let us look at what has happened in USproperty prices running up to the endof the first quarter of 2007 from the USOffice of Federal Housing EnterpriseOversight

This clearly demonstrates a significantchange in the market, which started in2006 and continued throughout thatyear and into 2007. The continued

CURRENT MARKET TURBULANCEWAS THIS PREDICTABLE & WHERE WAS THE STRESS TESTING?


7

Hedge fundsdepend for theirsuccess on thequality of theirfinancial models.

collapse of this market would therefore have been theexpected position, rather than the unexpected event.

What this tells you clearly is that the US property market wasmoving out of its normal trend and this should have beenrecognised. Were there any other indicators?

This wonderful chart from WTRG Economics alsohighlighted that the oil price has been moving out of its

normal tradingcycle.

This chart alsoprovides a warningsign thatsomething elsemight be about tohappen – there isa clear 10%resistance lineoperating. Theseare just a few ofthe indicatorswhich RiskReward typicallylooks at and theywere all indicatingthat something

was likely to happen. It was not would something happen –but what would happen. Accordingly we would have expected

firms to have undertaken a higher level of stress testing in2007 having read these signals that would have previouslybeen the case.

So what happens if you fail to see the signs? Effectively yourmodel becomes worse than having no model at all. Stocksthat are predicted to rise will fall. Stocks or positions that arepredicted to be offsetting actually become positivelycorrelated – basically the model is worse than useless and abank suffers losses.

Perhaps one of the benefits of this failure will be an increasein the use of stress testing and scenario modelling.

Banks are not interested in lendingsmall amounts of money to companiesor individuals that are either difficult orexpensive to service, or are seen asrelatively high risk. Accordinglytraditional banking is not available tothem.

MicroFinance is designed to meetthese needs, providing small amountsof funding to a distributed client basethat is in need of assistance but will bemotivated to make repayments. Thissort of finance is clearly beneficial to aneconomy. The provision of such smallloans enables the individual to rise outof poverty and become a productivemember of society.

The problems are as follows:

■ The banks are not interested since

the market is expensive to exploit –the returns are better elsewhere.

■ The customers have a distrust forthe banks

■ There is a propensity for such loansto be at rates which are at bestpunitive.

The challenge is to develop more suchinstitutions where profit motive is notthe only driver, enabling a morepaternalistic or egalitarian approach tobe adopted. The important thing is toensure that the customer feels obligedto make the repayment. This can oftenbe achieved by lending to thesecondary income generator in a family,the spouse rather than the breadwinner.It can also be of assistance if there areregional development funds to leverage

such opportunities. Another approachis to work through the organisationsthat the customers trust, perhaps retailoutlets or petrol stations. These couldprovide a funds transmission system toenable micro finance to flourish.

For the regulators a change of approachis required. It would be wrong to assesssuch an institution on the same basis asa multi national bank. They are simplerinstitutions and require a light touch inregulation together with simple tounderstand systems and controls.

What is certain is that the demand andgrowth of micro finance will continuein the long term. It is now just a part ofthe financial services industry whichneeds to receive appropriaterecognition.


8

THE CHALLENGE OF MICROFINANCEIN MANY COUNTRIES OF THE WORLD A MAJORITY OF THEPOPULATION OPERATES OUTSIDE OF THE CLASSICAL FINANCE SECTOR.

CURRENT MARKET TURBULANCE CONTINUED

The challenge is to make the processcost effective whilst meeting therequirements of the regulations. Theopportunity is to add value to your firmwhilst implementing these obligations.

Much has been written about the BaselAccord and the approaches taken forcredit and operational risk – withtrading book issues remaining with asimilar calculation as that employed inBasel 1. The key problem that we faceis that the new Basel Accord does notreally align well with total riskmanagement.

Consider first market risk, now knownas trading book issues. Essentially thecalculation is to come up with a markto market assessment of trading openpositions. This then takes essentiallyhistoric data to calculate Value at Risk(VaR) data. It is working in the fairlyexpected and current modelling space,using historic data.

Basel II has changed credit risk. Themodelling is now, if using the internalratings based approach, based upon aninternal assessment of Exposure atDefault, Loss Given Default andProbability of Default. Theseassessments are essentially to be basedon historic data ideally taken across thecredit cycle. Of course for many firmsthis is difficult to achieve, so a dataquality problem clearly arises. Theassessment is therefore entirelybackward look working on expectedloss.

This then brings us to operational risk– introduced for capital calculationpurposes for the first time with Basel II.Using a combination of internal andexternal loss data, control and risk selfassessment, scenario modelling andstress testing and excluding losses thathave been budgeted for, a forwardlooking loss expectancy is developed.This is looking towards the unexpectedlosses that might arise, rather than theexpected losses that regularly arise –effectively marking to future.

In operational risk the Bank forInternational Settlements (BIS) hasrecognised that a bank needs capital toprotect itself against unexpected losses,rather than both budgeting for a lossand then taking capital. Put simplythere is no point in calculating thecapital required for expected losses ona credit card book. The losses areregular and similar year by year. Ascredit cards are priced the losses thatare expected to result are factored in.There is no need for capital; it is simplyfactored into the pricing. Howeverboth credit risk and trading book issues(Market risk) would require capital tobe maintained in such cases.Operational risk does not.

There are of course no pillar onecharges required in respect of liquidityrisk, reputational risk and strategic risk.This should not mean that a bankwould place less priority on such areas,rather that they are unable to influenceactively the calculation of the capital tobe maintained. Because it is seen asdifficult the result is that the capitalvalues are actually calculated by thesupervising authority and imposedupon the institutions as a pillar twocharge.

The challenge for a risk manager is tobuild this into a consistent framework.Regardless of what Basel II says, theBoard of a bank would want to knowthe impact of a scenario or event on thetotality of their risk framework –credit, market, liquidity, operational,strategic or reputational risks. They areas interested in loss of income as anincrease in costs. Accordingly someform of probabilistic modellingapproach must be adopted across thetotality of the risk framework.

This means changing market and creditrisk. In the trading book the mostinteresting areas would be the 99.9%one day loss value (ie the loss thatwould occur one in a thousand days),or perhaps even the 99.99% one dayloss (the loss in ten thousand days, or30 years). The loss would be net of any

provisions that are created for such apossibility.

The same would occur for credit risk –the loss that could occur in a calendaryear from the existing book under aseries of scenarios. Inthis case looking atlosses over the entireeconomic cycle maynot be enough, soadditional modellingwill still be required.Again any capitalvalue will be net ofthe provisions thathave been made.

Operational risk at99.9% VaR alreadymoves in the rightdirection and meetsthe requirementsthat we are nowsetting. Similarapproaches can betaken for theremaining risk typesand we wouldrecommend that a consistent view betaken (ie 99.9% VaR net of budgeted orexpected losses).

If this is all implemented then theBoard will be in a position to evaluatethe totality of the risk framework on aunified basis and also to undertakeappropriate modelling. There should beincreased efficiency and better decisionmaking by the bank. In terms ofsoftware, the similarity in modellingapproach suggests a unitary softwaresolution.

So there is a real challenge here – butdo not just do it for Basel, instead doit because it will add value to yourfirm.

TOTAL RISKMANAGEMENT & BASEL 2THE BASEL ACCORD PROVIDES INSTITUTIONS WITH ACHALLENGE, BUT ALSO SOME OPPORTUNITIES.


9

“..There are ofcourse no pillarone chargesrequired inrespect ofliquidity risk,reputational riskand strategicrisk”

Whilst we have been active in many countries, wehave not undertaken assignments withinZimbabwe at this stage – however we have seenthe developing issues impacting the Zimbabweeconomy.

This is not a political article, rather it looks at theproblems as they currently manifest themselvesand seeks practical solutions.

The key issue currently is the rampant levels ofinflation, reputedly at up to 12,000% or about 1%an hour (perhaps four times the official publishedlevel). When inflation reaches this level thefinancial systems start to fail and commercegenerally leaves the mainstream to be replaced bybarter. Businesses continue to fail, unemploymentand interest rates rise and the agricultural sectorgoes into a state of decline leading to increasedhardship.

There are a series of options available to a country at thistime. These include:

■ Controlling the money supply■ Controlling prices■ Controlling the currency■ Stimulating the economy

Not all of these options are available to Zimbabwe. Inprevious cases where a country has been in significantdistress, significant problems have occurred. In the case ofthe Russian default, for example, interest rates hit 150% andthe stock market declined by 80%. South American casesidentified a similar pattern of behaviour.

There is no doubt that a radical solution is required. Basicallylocal currency is no longer trusted, leading to the growth ofbarter. Price controls put enormous pressure on companies,which fail and therefore are unable to support the necessaryrecovery of the economy when the situation is suitable.Accordingly a solution that results in a change to thecurrency is the most sensible approach.

We would suggest that the current currency be discontinuedfrom a set date, perhaps five working days after theannouncement. At that time all currency holdings must beconverted into a new currency. Due to the weakness of thelocal currency a currency that is interchangeable internallywith a recognised external currency (for example the USDollar) should then be implemented. The interchangeability,which must be enforced, will ensure that the currency remainsstrong.

With the basis of a strong and secure currency, Zimbabweshould then seek to grow its economy. The twin issues ofagriculture and industrial production should both beaddressed through direct government intervention, providingfiscal advantages for excess production and penalising underproduction. The excess production and the consequentproduction of wealth will then progressively drive theeconomy.

We have no doubt that a vibrant Zimbabwe would be goodfor Southern Africa and are also convinced that the climate ispotentially right for this to be achieved.

THE PROBLEMS OF ZIMBABWERISK REWARD SPECIALISES IN PROVIDING RISK MANAGEMENTTRAINING AND CONSULTANCY WITHIN THE DEVELOPINGWORLD, AND IN PARTICULAR WITHIN AFRICA.


10

What a quarter we have just had.Suddenly the credit market has becomea high risk environment in which tooperate as the sub-prime creditproblems of the USA start to travelaround the world. We have all seen thewrite offs by the various global banks asthey seek to mark to market paper thatthey had originally thought wasextremely low risk, but what really iscausing the problem?

Risk Reward has been predicting thisscenario for two years and considerthe subprime “crisis” to be only asymptom of a much greater problem.

Clearly the rates need to be higher tocompensate for the higher likelihood ofdefault that clearly occurs. There arehowever two effects that we are seeingin the market. The first is true concernsover an increased likelihood of defaultfrom US based borrowers withdeficient credit records. This is in partdue to the issue discussed in thesecond section of this newsletter(Wither the USA?). However normallyyou see this type of an issue when theinterest rates have increasedsignificantly and also costs have putpressure on narrow budgets, whilst theeconomy is not in growth. Is this really

the case in the US?Let us look at whathas happened to USlong term interestrates over the pastseven years.

Do you see anyevidence of anincrease in rates?We suspect notand actually itdoes not reallymatter which dateset you look at. Soif borrowing is notincreasing, are costsincreasing? Wehave seen that oilprices have goneup significantly.

However is this enough to really causea major downturn in the earningspotential of the US borrower with apoor credit record?

Whilst thereundoubtedly hasbeen an increase inthe number ofdefaults within theUS banking sector,these are notcurrently sufficientto causeinternationalconcerns and areonly returning tohistoric norms after aperiod of unusuallylow default rates.

WHAT REALLY CAUSEDTHE SUB-PRIME CRISIS


Securitisation has an EffectAs credit derivatives have grown, this hascombined with the growth in the marketfor securitised or collateralised products.Put at their simplest this is a way for aportfolio of subprime assets to beconverted into what purports to be anasset of higher quality. To achieve this thefollowing model is adopted:

�� !� ��"�� #

! $%&'()*

+��,!!

+��,!

+��,!$

+��,!%

+��,!&

+��,!'

+��,!(

+��,!)

�� ! ��"�� #

�� )��"��"&�� )��#��#��%*��$�"&�%�" ��%��%��%(�� (�%��%�*�*%�� $��"�� #�� %*��*�#��"��#��+�� )��%�"�� %**��&��"��)�)��%�" ��"#�� $+��

�� .��/��0�� 00��0��0��0��0��.��0��/��0��345�"��6�� /��0�� /��/��.��7��

�� !� ��"�� #

! $%&'()*

+��,!!

+��,!

+��,!$

+��,!%

+��,!&

+��,!'

+��,!(

+��,!)

�� ! ��"�� #

11

“Is this enoughto really cause amajor downturnin the earningspotential of theUS borrowerwith a poorcredit record?”

BOOK OF LOANSSold to a Special Purpose Vehicle.

SECOND TRANCHEWill only suffer default

if first.

FIRST TRANCHE OF BONDSWill suffer first.

THIRD TRANCHEWill only suffer default if first andsecond tranche is extinguished.

Sub-Prime LendingData source: US Treasury

Sub prime lending is the practice of making loans toborrowers who do not qualify for the best marketinterest rates because of their deficient credithistory. A sub prime loan is offered at a rate higherthan A-paper loans due to the increased risk.

WHAT REALLY CAUSED THE SUB-PRIME CRISISCONTINUED

The consequence of this is that the first tranche is extremelyhigh risk, with the second tranche being lower risk and thethird tranche actually being a good quality asset. This type ofstructure is used in the US for mortgage loans and otherassets that can be easily packaged – including sub-prime debt.

Taking sub-prime the first tranche is highly likely to sufferlosses and will therefore have a very low rating, but a highinterest rate. The second tranche is probably roughly at therate of the original portfolio of assets. It is the third tranchewhich is the high quality asset and may well represent 50% ormore of the total portfolio of assets. This tranche will be amuch higher quality asset than the originating loans and willtherefore have a prime rating – and a consequently lowerinterest rate.

It is these assets which are then sold internationally. Not thefirst tranche of assets, but the second and third tranches.Indeed it is mainly third tranches that are being held inoverseas funds and are now being written down – yet there islittle evidence to support there actually being manyincidences of significant default in these third tranches.

The Real Driver – US LegislationThe real issue that has been impacting the sub-prime marketresults from the difficulty that some banks have had in valuingassets after the credit market turmoil of the summer. Typicallywhere assets cannot be ‘marked to market’ because no marketis available, a ‘marked to model’ system is used. This processhas been incorrectly derided by critics as ‘marking to myth’.

The US has implemented a new standard US FinancialAccounting Standards Board disclosure rule 157, which cameinto affect on November 15. This required that assets bedescribed under three broad levels:

Level 1: Quoted prices: Prices (unadjusted) in activemarkets for identical assets or liabilities that thereporting entity has the ability to access at themeasurement date.

Level 2: Inputs other than quoted prices included in Level 1that are observable either directly or indirectly:• Quoted prices for similar assets or liabilities inactive markets;• Quoted prices for identical or similar assets orliabilities in markets that are not active,An example of a Level 2 input would be the LIBORswap rate.

Level 3: Unobservable inputs:• Unobservable inputs reflect the reporting entity’sown assumptions about the assumptions thatmarket participants would use in pricing;• The reporting entity’s own data (adjusted ifinformation is reasonably available without unduecost and effort to reflect market basedassumptions).Examples of Level 3 inputs include historicaldefault and returns for an entity’s portfolio.

This is another case where the law of unintendedconsequences really applies. The standard was intended toenable readers to establish which assets are being valued withcertainty – and which with uncertainty. The market is thentaking the view that anything that is uncertain must bynecessity be high risk and related to the sub prime crisis, soany such asset is being written down.

The Goldman Sachs ExampleOne of the firms that is often quoted as having problems isGoldman Sachs. However Goldman said that of the $72billion level three assets, it wholly-owned only $51 billionworth and that private equity investments and real estatecomprised half of the remainder.

A Goldman Sachs spokesman said that “private equity and realestate assets were placed in the level three class – the categoryfor assets that are difficult to value – under the new standard.The remainder is made up of leveraged loans that were movedfrom level two to level three after the credit crisis kicked in”(ie because the prices are now difficult to obtain).

The spokesman said: “There has been a lot of talk about howlevel three assets are difficult to value. We fundamentallydisagree. Our point of view is that you can value everything –and if you’re an investment bank it’s your business to.”

So it is essentially ignorance in the market that is causingthese write downs. This in itself is interesting because if weare correct in our assumptions that the write downs are notactually based upon fundamental problems, but are insteadbased on a hastily introduced and quite frankly rather illogicalaccounting standard, then if the firms retain those assets afterthe market turbulence many of the write downs will actuallyreverse.


12

Predictions area tricky business—how did we do?

Last year Risk Reward predicted the following:

Global equities – 5-10% growth

UK equities – 15% growth

US equities – 3-5% growth

Middle East equities – 5% growth

UK residential property – 12-17% growth

UK commercial property – 5% reduction

US residential property – 5% reduction

US commercial property – 10% reduction

UK Interest rates – no change

US dollar – more falls

Other predictions:

Terrorist attack at anairport

Major financial failure

US heading for recession Q3 2007

THE 2008 RISK REWARD PREDICTIONS


UK equities have actually grown nearer 4% with USequities between 3-6% depending on the index. UKresidential is up 7% and interest rates in the UK haveincreased from 5% to 5.5%, having come down from 5.75%.US property has declined and the US dollar has fallen.There was an attempted terrorist attack at Glasgow airport,Northern Rock failed and the US is having problems. Onbalance the predictions are not too far from thosepredicted.

2008 is actually harder to predict. For UK equities we areexpecting modest growth due to the reversal of decline inbanking stocks and predict a 7% increase. We remaincautious over the US economy prospects and thereforeexpect only a 3.5% increase in US indices.

Trying to predict $/£ rates is also very hard since twoscenarios do appear. On balance we expect the $ tostrengthen during Q1/2008, but then to weaken for therest of the year to a rate of around 2.05.

Global commercial and residential property prices are indecline and we can see no good news for either the US orthe UK. We expect residential property in the US todecline further during 2008, but UK property prices toincrease by a modest 3% year on year.

The major risk remains the US debt. The most recenttreasury auction did receive the required level of interest tosuggest that the US debt remains serviceable atpresent – perhaps given the paucity ofother assets available to the globalmarket. We do not expect theseconditions to operate throughout 2008and remain concerned in Q3/2008. Wedo however expect the currentliquidity crisis to effectively be overby end of Q2/2008.

On the international stage we areexpecting two major internationalfigures to depart during 2008.We are also concerned thatpolitical uncertainty willexist in South Africapending therealignment of politicalparties to represent thepost apartheidparadigm.

13

Perhaps you have heard this story by now? Bank lends moneylong to its customers to buy property. Bank funds this bydeposits, but finds that increasingly difficult so resorts tousing short term interbank money market funding which ischeaper.

Northern Rock was a building society based in Newcastle-upon-Tyne which converted into a bank and became the UK’sfifth largest mortgage lender. It operated a virtuous circle of

business. The mission talk aboutproducts, efficiency and growth, butthe “Virtuous Circle” replacesefficiency with cost control. Perhapsthat is where the real problem lies –was it wrong for a bank to rely soheavily on money markets?

Did the money markets themselvesdry up and cause the problem – or wasthe view taken by Northern Rock thatsuch funding was too expensive.Perhaps the market took the view thatunder these extreme stress conditionsNorthern Rock was too much of a riskand therefore a run on the bankbecomes inevitable.

Where was Risk Management atNorthern Rock? Clearly they were reviewing liquidity risk fortheir 2006 statutory accounts show the following:

LIQUIDITY RISKLiquidity risk arises from the mismatch in the cashflowsgenerated from current and expected assets, liabilitiesand derivatives. The Group’s liquidity policy is to ensurethat it’s able to meet retail withdrawals, repaywholesales funds as they fall due, and meet currentlending requirements. It also ensures that it meets FSAliquidity rules, which require the Group to be able tomeet its sterling obligations without recourse to thewholesale money markets for a period of at least fivebusiness days.

To ensure that it meets these requirements, the Grouphas approved a Liquidity and Treasury Policy Statement,compliance with which enables it to meet both therequirements of the FSA and internal policyrequirements. This is achieved by managing a diversifiedportfolio of high quality liquid assets, and a balancedmaturity portfolio of wholesale and retail funds. Longerterm funds are raised through the Group’s Medium-Term Note programmes. The board reviews the PolicyStatement annually, and on a more frequent basis if anysignificant changes are proposed or required.

As well as approving the types of liquid asset that maybe bought, the Liquidity and Treasury Assets PolicyStatement sets out approved operational limits andestablishes operational guidelines for managing theGroup’s liquidity risk. The Treasury Director monitorsliquidity on a daily basis, using daily cashflow liquidityand sterling stock liquidity reports, together with daily

movement reports, portfolio analyses and maturityprofiles. The board receives monthly liquidity reportsanalysing the liquid assets and showing the percentagesof assets held in each asset type.

This is clearly what you would require a prudent institution todo. They are managing the risk in the book through acombination of techniques. However they were caught outwhen the markets changed on them – so what did they dowrong?

Clearly we do not know the full story at this time, but it isclear to Risk Reward that Northern rock were not taking fulladvantage of the derivative techniques that were available inthe market place. Typically institutions try to obtain fundingwhen they are under stress, which is quite simply the wrongway to manage a business. What is more effective is to put ina series of derivatives atan early stage when youdo not need the funding.

If a collar is placedaround interest rates withthe firm giving up someof the upside to protectthemselves from thedownside, then they arein a position where thechange in interest ratesdoes not really cause anyeffect.

The consequence of thisis that the firm is able toborrow at the higher ratewith the derivativepicking up the slack. Theuse of a collar willtypically ensure that the cost of such an approach is eithermodest or negligible to the institution.

Hence a proper risk management approach would have beento recognise that Northern Rock does not make moneythrough the management of liquidity and that this risk shouldbe hedged out to the maximum extent. By using a collarconsisting of a series of purchased options the totality of therisk could have been much better controlled and we suggestNorthern Rock would have weathered the crisis withoutintervention.

THE FIASCO THAT WASNORTHERN ROCK


14

“Institutions tryto obtainfunding whenthey are understress, which isquite simply thewrong way tomanage abusiness. ”

It is now very clear that currentfinancial regulation has not helped thecrisis in liquidity. We have had runs onbanks, major disruption in globalfinancial markets and a meltdown in theprices of some financial assets.

At the heart of this is a common fallacyof financial regulation – that capital isthe answer to everything and that 8%of risk weighted assets is the right level.Examining this even briefly must raisequestions in the mind of even the mosthardened regulator. At the heart of theissue is how to regulate a bank.

If you take some form of calculationbased on risk weighted assets, then iteffectively considers what normally

happens. The capital calculated in thisway would represent the funds that theregulator views as the bank requiring tocover normal operations.

However what we have seen is thatproblems occur in times that are notnormal and that capital is not a usefulway of protecting the firm at that stage.Liquidity risk in particular is not helpedby capital, since the assets in which theliquidity capital would be investedthemselves could become illiquid andexacerbate the position.

If capital was designed to cover remoteevents – perhaps 0.1% likelihoodevents, then in 99.9% of cases thecapital would be excessive to the actual

requirements. Effectively it would forcethe banks to incur a loss every year inthe expectation that eventually theywould have enough capital to copewhen the bad year actually hits, if itever does. No business can workeffectively on that basis since this willof necessity result in charges tocustomers being higher than should bethe case. What is needed is for theregulators to move to a stresstesting/scenario modelling approach toregulation and to look for processesand controls that would operate undersuch circumstances.

These are likely to be in the system as awhole rather than the capitalcalculation of a single bank.

THE PROBLEM WITH REGULATION

For anyone reading this from anycountry other than the UK thethought of a unitary regulator for thewhole financial services industry (theFSA) that is separate from the Bank ofEngland may be surprising.

The Bank of England is responsible forthe money supply and the managementof inflation, whilst the FSA regulatesfirms.

In the normal course of events this isclearly fine – the Bank of England setsinterest rates in the knowledge thatfirms will meet the requirements set bythe FSA. What Northern Rockhighlighted is that in abnormal timesthere is a need for joined up writing.

The Bank of England signalled thatNorthern Rock would receive supportby issuing the following statement

“Tripartite Statement by HM Treasury,Bank of England and FinancialServices Authority 14 September 2007‘The Chancellor of the Exchequer hastoday authorised the Bank of Englandto provide a liquidity support facilityto Northern Rock against appropriatecollateral and at an interest ratepremium. This liquidity facility will beavailable to help Northern Rock tofund its operations during the currentperiod of turbulence in financialmarkets while Northern Rock works tosecure an orderly resolution to itscurrent liquidity problems. The

decision to authorise was made by theChancellor on the basis ofrecommendations by the Governor ofthe Bank of England and the Chairmanof the Financial Services Authority inaccordance with the framework set outin the published Memorandum ofUnderstanding between the Bank, FSAand HM Treasury.

The FSA judges that Northern Rock issolvent, exceeds its regulatory capitalrequirement and has a good qualityloan book. The decision to provide aliquidity support facility to NorthernRock reflects the difficulties that it hashad in accessing longer term fundingand the mortgage securitisationmarket, on which Northern Rock isparticularly reliant.

In its role as lender of last resort, theBank of England stands ready to makeavailable facilities in comparablecircumstances, where institutions faceshort-term liquidity difficulties.”

The consequence of this is that everyinstitution is now covered in what mustbe one of the most unusual decisionstaken in banking for many years.Clearly this public statement causedthe customers of Northern Rock toseek to withdraw a higher level of fundsfrom the bank than would otherwisehave been the case, resulting in queuesaround the block of the offices.Historically the Bank of England wouldhave worked silently behind the scenes

to solve the problem – their inability todo so in this case put the entirebanking sector at risk and has resultedin a significant loss to the UK taxpayer(who has some £30bn currently at risk,or £730 for every UK taxpayer).

So what are the lessons from this? Themost important thing is for governmentsto design regulatory systems andstructures which operate effectivelywhen the institutions are under stress.This means that one institution needs tohave control of the assets of the country(ie the money supply) and theregulation. Further it needs to berecognised that having an independentbody purely responsible for the moneysupply cannot be effective since understress conditions since under thoseconditions that institution must cease tobe independent. So what is the option?Historically the Bank of Englandundertook regulation and managed themoney supply, with interference fromgovernment. It is our view that actuallythat is a better system than the amalgamthat currently operates and we thereforewould cede the FSA back to the Bank ofEngland and eliminate the need for anindependent regulator in its totality. Theonly other alternative would be to returnthe setting of interest rates to thegovernment and make the Bank ofEngland purely an arm of governmentinteracting with market participants, butwe view that as being a suboptimalsolution.

WHAT IS THE ROLE OF THE BANK OF ENGLAND &THE FINANCIAL SERVICES AUTHORITY (FSA)?


15

We have been increasingly frustrated by the failure of themarket to deal with the causes of the contagion in thebanking sector and that instead they seem to be focussed ontreating the symptoms and looking for scapegoats. We do not

believe that the problemsstarted with mortgage failuresin the USA, rather that theincreased problems of themortgages are theconsequence of a series offailures.

Firstly, SFAS 157 (whichrequired reporting of mark tomodel assets in the US) andIAS 39 (which imposed fairvalue accounting and tookaway the right to hold tomaturity assets in certaincases) were certain to lead toexactly the problems we areseeing. This was entirelyforeseeable. It is also clearthat fair value is not mark tomarket if a market is failing to

behave in a rational fashion.

The consequence of these two standards was that securitisedmortgage assets, which were designedto provide low risk held to maturity assets for the bankingbook, could not be used for the purpose forwhich they were designed. In the absence of any other buyerfor the assets the answer is obvious –freefall.

Secondly, many of the banks have lost exactly the expertisethat they require to deal with difficult times, having refreshedtheir teams such that too many had developed their roles inidentically positive market conditions.

Thirdly, Basel II focussed on operational, credit and marketrisk to the detriment of work being conducted on liquidityrisk. Worse than that the focus on the expected end of theloss curve swayed management attention away from theunexpected events which are really what matters.

Further, politicians and reporters have been seekingscapegoats without the right level of understanding of theissue and effectively aim at the wrong targets.

So what should be done? Firstly stop looking at the banks asif they are some form of bizarre gambling machine. Secondlyrevise SFAS 157 and IAS 39 such that assets can be held atintrinsic value. If a tranche or layer of a securitisation of a setof mortgages is only expected to lose 10% of its value, then itshould be written down by 10% - not 85% as is currently thecase.

Why, then, were the signs of problems in the banking sectorignored?’

WHY WERE THE SIGNS OFPROBLEMS IN THE BANKINGSECTOR IGNORED?


16

Politicians andreporters have beenseeking scapegoatswithout the right levelof understanding ofthe issue andeffectively aim at thewrong targets.

What an amazing year to be a riskprofessional. With the problems ofNorthern Rock, Bear Stearns andSociete Generale to name but three,risk management has never been incloser focus than is currently the case.In this issue of the Risk Reward updatewe take a look at the current riskclimate and the regulatory responses.We also look for the causal links thathave given rise to the current climate ofuncertainty. In so doing we hope thatour readership will gain an insight intothe world of risk in banking and itsimpact on the global markets.

There are some clear messages for therisk management industry and many ofthese relate to stress testing andscenario modelling. The concernsabout risk management techniqueshave been clearly identified within theBanana Skins report which we discusslater in this issue. In brief we believethat all risk managers need to considerthe following:

Stress TestingThe objectives of stress testing are totake a unitary variable and extend thisto a plausible extreme.

The Bank for International Settlementshave identified that more stress testingneeds to be undertaken bymanagement of institutions. Theproblem has been that management canonly see plausible from the currentmarket perspective. Of course plausibleis likely to be much more extreme. Ourfirst clear message is that stress testingshould be extended to include plausiblebut unlikely events.

There can be no doubt that theliquidity position of the first half of thisyear (or indeed the previous two yearsor so) was outside of the stress testingconducted by most management.There can be no doubt that had themanagement of Northern Rock actuallyapplied a comprehensive series of stresstests, leading to management action,then the current problem could havebeen avoided.

Scenario ModellingIt never ceases to amaze a professionalrisk manager how the same type ofevents recur. The problems at SocieteGenerale are a case in point although inno way unique. Providing staff with the

ability to conduct fraud or to misleadmanagement inevitably leads to someparty taking advantage of this at somestage.

Scenario modelling, as readers of ourRisk Reward Update will know fromthe past, is used where more than onevariable is required to be stressed. Ittakes information from publishedevents that have impacted uponanother institution and applies thelessons to your business. The mistakethat many firms make is to take theexternal event too literally, for that isnot the point of the exercise.

What is clear from Societe Generaleand Bear Stearns is that neither firmwas able to learn the lessons from otherpublic events and that a potentiallyavoidable problem became a disaster.

Risk ModelsAgain this appears as a significant riskwithin both the Banana Skins surveyand also speeches and papers appearingon the web site of the Bank forInternational Settlements(www.bis.org). The problem with riskmodels in general are as follows:

1. The assumptions that are inherent inthe risk models are not clearlyarticulated to enable management tointerpret whether they remainappropriate

2. The risk models portray a speciouslevel of accuracy which neither theunderlying assumptions nor thequality of the data are able tosupport

3. Modelling techniques areinconsistent so the management areunable to gain a clear understandingof the true position of the firm andthe actions that they are able to take

4. The models themselves are notregularly stress tested to see howthey cope with changing marketconditions

5. Risk specialists working in differentrisk areas tend to favour differentapproaches. This exacerbates theproblem that there is likely to beinconsistent modelling.

Senior Management TrainingMany senior management have risen tosenior positions during the lasteconomic cycle. Depending on whenyou consider this to have started it has

lasted for some 15 years during whichtime a benign market for banking haspredominantly applied. Management,including risk management, trained andpromoted during this period have nothad an exposure to the stressenvironmentsof the past,accordinglythey may beunable to graspthe currentissues and theactions to takein the bestinterests of thefirm. Perhapsthey are tooclose to theissue. It couldof course be afault of thetraining thathas beenprovided whichoften focuseson materialsprovided anddesigned byacademicinstitutions –theoreticallybrilliant,practically useless. This is compoundedby the confusion and focus of theregulators on expected as opposed tounexpected loss. We shall revisit eachof these issues in future issues of theRisk Reward Update and wouldwelcome your views on what youconsider to be the key issues of the day.Please send your ideas [email protected]

CAN YOUR RISK SOLUTIONS COPEWITH CHANGE?


17

‘There can be nodoubt that had themanagement ofNorthern Rockactually applied acomprehensiveseries of stresstests, leading tomanagement action,then the currentproblem could havebeen avoided.’

Recently Dennis Cox, the CEO of Risk Reward Limited,presented as part of a panel at the Investment Horizons eventorganised by the UK based Securities and InvestmentsInstitute. At that event he promised to develop some of thesethemes in the next Risk Reward Limited update.

In terms of our views of the current commodities markets weconclude that there are parallels from the past which do needto be considered. There have been a number of times in thepast when markets have left reality with the price of assetseither massively exaggerating a trend, or having the oppositeeffect. It is our view that such matters are entirelypredictable.

Tulip BulbsThe first event of what might be called the modern age wasthe Dutch bulb bubble.In this case the humbletulip bulb was thesubject of majorspeculation resulting in apricing spike. Thereasons for this areperhaps less importantthan the result and werethe first of a series of“bubbles” ranging fromthe South Seas bubble tothe internet bubble.

RiceWhat is most importantis to notice the trend – firstly there is a demand led trend andthen there is a speculative trend. The end of the speculativetrend is a warning that the market is likely to collapse – theonly question is how high is the peak and when will themarket collapse?

Consider a staple food like rice, for example:

This is a graph downloaded from CME Groups web site.Notice once again the trend. During the period 2002-2007there is a demand led increase in the market price of ricewhich lasts until the middle on 2007. At that time speculationtakes over and the price exceeds 2,000 in Q1 2008 when theextrapolation of the previous trend would suggest perhaps1,300.

The Risk Reward view is that the long term demand trend forcommodities will apply in the longer term and therefore thegraph will revert to that position, suggesting a real price forrice (Rough) at nearer 1,400 than the current price.

GoldThe key issue is whether this is replicated in the case of othercommodities. Let us consider how the gold price has moved:This graph is downloaded from www.usagold.com and showssome interesting issues. Once again if there is a demand trendwhich in this case operates during the period 2001-2005. Aspeculative trend then takes over, and the gold price spikes.At the peak there is a high level of price volatility which weexplain as being the impact of a demand led curve impactingupon a speculative curve. The demand curve would suggest anatural price for gold of perhaps 575 and our view is that theprice will long term revert to this trend.

PlatinumTaking this further let us review the movements in theplatinum price:

Once again there is a demand pull operating between 2001and 2007, then the speculation takes over to hit a high pointand a period of volatility. This would suggest that the naturalprice of platinum is in fact perhaps 1,600 and again that thelong term trend will revert to such a position.

CopperOf course not all markets actually have the same level ofspeculation. In terms of such markets Copper is perhaps aprime example. Because the copper price was previouslyexploited by unscrupulous traders, this time they do appearto have kept away. Look at the following graph downloadedfrom www.kitco.com:

WHAT IS HAPPENING IN THECOMMODITIES MARKETS?


18

Here there is some evidence of speculation on April-June2006, but the price has reverted to its long terms demand ledtrend. Indeed we would expect the copper price to remainabove 4,000 for the foreseeable future.

OilSo the judgement is clear – it is our view that the market iseffectively demand led and that speculation moves the priceaway from this trend, but that it reverts over the longer term.Let us now apply this through process to the oil price:The graph that you normally see produced is as follows:This graph care of WTRG Economics shows a relativelysteady growth curve, however let us look at the longer termtrend:

Now we see rather a different trend. Here you see a rathervolatile demand curve during 1994-2004 to be followed by aspeculative curve. This has continued from 2004 to thecurrent date. What we are now seeing is the volatility thattends to be a signal for the peak of the trend.

Of course in the case of the oil price it is hard to remove theimpact of speculation, but our view is that the natural price ofoil is in the $50-$75 band. This is consistent with the view ofSaudi Arabia which is stating that $60 is the natural price.

The question is not will the price revert to a long term trend;it is when will this happen.

One of the clear messages that come from this is to the teamsthat are setting interest rates in country around the world.This temporary speculation causes externally generatedinflation which will revert. It is important for governmentsand central banks to discount such inflation in theirmanagement of their economies. The classic answer ofincreasing inflation to reduce demand in the economy andsuppress inflation will have the opposite effect this time sincethe inflation pressures are externally generated, rather thaninternally driven. The best thing that the economists can do isnothing.


19

In previous updates we have discussed IAS 39 and itsproblems. Of course the problem that we identified then hasnow occurred. To explain what is happening you do need togo back into the vagaries of IAS 39 (and its ill consideredcousin SFAS 157).

IAS 39 states that assets may be held to maturity in thebanking book. If there is a permanent diminution in valuethen the assets should be written down, the comparison beingagainst what is referred to as fair value. If anything other thanan insignificant amount of the assets are sold then all held tomaturity assets must be shown as fair value and gains andlosses should be taken through the profit and loss account.

Worse than that any firm that sells anything other than aninsignificant amount of held to maturity assets loses the rightto have held to maturity assets for a period of three years.

Let us look at the current crisis and what is actuallyhappening. Look at the following graph:

This is from the economist. What you can see is that AAArated bonds have been written down by 20% under thesecurrent rules and the misinterpretation of fair value that iscurrently occurring. The statistics show that for a AAA ratedtranche of a mortgage book to be impacted by a downturn inthe market, 29% of the portfolio needs to go into arrears. Thefigures for Northern Rock were published today – arrears are0.75%. Not 1%, not 5%, not 25%... but Northern Rock bondswill have been written down by 20% without any prospectthat there will be a default.

What this actually means is that anyone that has sold suchbonds in the current climate has managed to crystallise a lossthat does not exist. The provisions that have been made bymany of the financial institutions also do not really exist. Ifthey were to hold the assets to maturity then they wouldreceive full value for such assets. Of course if they have soldsuch assets, probably under pressure from the media andpeople that should know better, then they have managed toincur an unnecessary loss.

What should be done? In our view if an asset does not haveany long term impairment and is to be held to maturity then itshould not be written down – the current speculative marketprice is irrelevant. In this case we have negative speculationcaused by the asset no longer being suitable for the marketfor which is was designed.

All that this requires is a formal definition of fair value and achange to the terms of Held to Maturity Assets. What is clearis that accounting standards that are developed withoutconsidering their implications to business will likely be fatallyflawed.

Come on IASB wake up and smell the roses.

THE PROBLEMS OF ACCOUNTING STANDARDS

What this shows is that the accountingrules are becoming increasinglycomplex and that many financialinstitutions in particular have achallenge in ensuring that theiraccounting and finance functions areboth up to an adequate standard and upto date.

The Institute ofCharteredAccountants inEngland and Wales(ICAEW) haverecognised thisproblem anddeveloped a newseries of products

to meet the demands of this market.Created using existing materialsdeveloped to ensure that all chartered

accountants meet required technicalstandards, for the first time non-chartered accountants can studyICAEW materials (either examinable ornon-examinable).

The objectives of this new programmeare clear. It enables the FinanceDirector and CEO to know that theirfinance functions are at least able tomeet the benchmark standard that theICAEW sets for technical competencein the following areas:

• Financial accounting• Management information• Business and Finance

Three other modules are also availableaddressing Audit and Assurance,Taxation and Law and nonexaminable

advanced courses are also availableagain using ICAEW producedmaterials.

These courses are available through theICAEW training partners and we arepleased to announce that Risk Rewardis the leading global training partner forthis extended programme.

THE NEED FORACCOUNTING TRAINING


20

‘The Institute ofChartered Accountantsin England and Wales(ICAEW) haverecognised this problemand developed a newseries of products tomeet the demands ofthis market..’

We start by publically answering someof the questions that have been posedto Risk Reward Limited consultants inrecent days and then look at thevarious areas where change may berequested or required, recommendingareas for action as appropriate.

1. The Key Questions

How long will the crisis last?We are regularly being asked for ourviews about the crisis. Our viewremains that there will remainturbulence in the financial markets untilthe conclusion of the US election andthat recovery will commence inDecember 2008. However therecovery will be sporadic and certainlynot euphoric. We expect 2009 will seea gradual return to what will become arelative normality, although the creditmarkets will remain cautiousthroughout 2009 and probably into2010.

Will more banks fail?This question has appeared in almostevery meeting that we have had withsenior bank management. As many ofyou will be aware we had expectedsome additional banks to fail in theJune to September quarter.

It is our view that the main failures havenow taken place and that increasinglythe remaining global players will nowbe in a position to capitalise on theirsuccess. Whilst a few secondary playerswill disappear through reorganisation ofthe sector, this will be due to mergerand acquisition activity rather than anyform of administration.

It has become clear in recent weeksthat most governments are prepared tonationalise or rescue any furtherstruggling banks.

How will investment bankingchange?There can be no doubt that investmentbanking will change as a result of recentevents. We believe that the days of the

feast are, with regret over. Howevernot all corporate activity on which theinvestment banking scene waspredicated will end. We do not expectthere to be a flurry of new issues foreither equities or bonds in 2009.Instead a few transactions will takeplace which slowly rebuild some degreeof confidence in the system.

There will be growth in 2009 and 2010but activity levels will not return tohistoric levels until probably 2012 t theearliest. Without the pipeline oftransactions which are the lifeblood ofthe investment banking sector, it willshrink dramatically with a few globalplayers together with niche boutiquesproviding the support. Basically weexpect that part of the industry todecline to perhaps only 25% of its sizeprior to the crisis.

2. The Global Regulator

Whilst there is no global regulator forthe entire banking industry, banks ofcourse each have a single HomeRegulator that takes ultimateresponsibility for the regulation of theinstitution. These Home Regulatorsneed to work closely with HostRegulators to make sure that theregulatory system works effectively.These rules have been revised fairlyrecently and should be allowed towork.

Of course that is not the issue that isconcerning the market. The suggestionis being made that we now requiresome form of global regulator to takesome level of international oversight.Our view is that any such developmentis bound to cause more problems thanit solves. At present there are twobodies which operate on a global basisand have impacted on the crisis.

THE CREDIT QUAKE: WHAT SHOULD OR SHOULD NOTBE DONE NOW?IT WORKS FROM THE POSITION THAT WE ARE WHERE WE ARE ANDTHERE IS LITTLE TO BE GAINED BY LOOKING FOR SCAPEGOATSAND CULPRITS. INSTEAD OUR CONSULTANTS LOOK AT A RANGEOF AREAS WHERE CHANGE COULD BE REQUIRED OR MAY BEPROPOSED AND CONSIDER WHERE ACTION SHOULD, OR SHOULDNOT BE TAKEN.


21

The first is the Bank for InternationalSettlements, which is essentially thecommittee of banking governors. It isnot answerable to anyone and is able tomake rules that impact on the globalmarkets. If there is a view thatregulation needs to be altered globally,then the Bank for InternationalSettlements already provides themechanism for this to be achieved.

If there is a view that regulation needsto be altered globally, then the Bank forInternational Settlements alreadyprovides the mechanism for this to beachieved.

The other global body is theInternational Accounting StandardsBoard. Again not really answerable toanyone it is able to design standards ofdisclosure, valuation and reporting forthe financial services sector which arethen imposed on the industry throughthe rules of individual stock exchangesand by regulatory pressure.

The key problem with any global bodyis oversight and that has been shown tocause difficulties in the current crisis. Asolution that may be theoreticallybrilliant could be practically useless.Increased scrutiny of these globalinstitutions is required – but whoshould do it and to whom should theyreport? Without oversight these bodiescan tend towards academic solutionswhich themselves create additionalissues. It is the absence of such areporting mechanism to ensureaccountability that results in ouropposing the creation of anotherunaccountable global body.

In our view it holds that the regulatorystatus quo remains the least worstsolution. However we do believe thatmajor and urgent changes to regulationare required.

3. The Bank for InternationalSettlements (BIS)

The BIS have been putting the globalbanking industry through Basel 2. Thisstandard has changed many times sinceits original drafting and is already out ofdate. There are real problems with thestandard which have becomeincreasingly clear during the currentcrisis.

If you look at the three risks which areaddressed directly in Basel 2 youimmediately see the concern. Creditrisk is primarily based on historic lossdata which should be across the creditcycle. The capital required currentlycovers both expected and unexpectedloss at a 99.9% confidence level.Market risk is based on a mark tomarket calculation using historic dataover a 99% 10 day VaR. This clearly isnot predictive and again covers bothexpected and unexpected loss.

Operational risk uses a range oftechniques (internal and external lossdata, control and risk self assessment,scenario modelling and stress testing)to identify at a 99.9% confidence levelexpected and unexpected loss.Budgeted losses can then be taken intoaccount and the result is supposed tobe a forward looking estimate ofunbudgeted and unexpected loss.

Strategic and liquidity risks are notaddressed in the Pillar 1 charges, butare instead covered in Pillar 2, hencethe lengthy ICAAP reports that manybanks are doing. So what is wrong?

Clearly a bank needs to implementEnterprise Risk Management, capturingeach risk they face on a consistent basisand enabling a Board to properlyunderstand their risk position under arange of plausible yet extremescenarios. This is also what theregulators require. There is no point ina regulator understanding how much abank would lose in credit risk from aspecific event if the impacts on theother risk types cannot be gauged.

Basel 2 needs to be completely redrawnto ensure that it deals with all risk typeson a consistent basis. It should requireEnterprise Risk Management to beimplemented in every bank worldwide.No rule should be produced by the BISwhich is contrary to this objective –accordingly the current SILOcommittee structure should also go. Thefocus for all risk types needs to be onunexpected loss regardless of risk type.

There is no point in the regulatorswasting their time looking at expectedloss, which is a decision formanagement as part of product pricingand profitability discussions. Far toomuch regulatory effort globally hasbeen wasted looking at things that, inretrospect, do not seem to matter.

4. Financial Education

As a firm that specialises in financialservices training we have beendismayed by the rather limited level offamiliarity with global finance that hasappeared in debates, politicalstatements and in the press.

Global finance has become of greatercomplexity and it is incumbent uponthe market to provide better training tothe population in general. This shouldclearly start in the schools and wewould hope that finance becomes anintegral part of general education.However in the short term we clearlyneed training for journalists andpoliticians so that they have someunderstanding of the matters on whichthey are expounding with such passion.Many public speeches and discussionshave exacerbated a difficult positionthrough repetition of half truths andrelatively incomplete analysis. Webelieve the global market shoulddemand a more qualitative approachfrom its political leadership andencourage the spread of qualityfinancial education and internationalbest practise, as is being encouraged bythe ICAEW, for example.

5. Legislation and SplitRegulation

The US continues to have amultiplicity of regulators for differentparts of the financial services industry.Put at its simplest this just cannotwork. It is important that the US nowmoves to combine all of its regulatorsinto a single Markets Regulatorenabling that regulator to understandthe impact of actions in one part of theindustry on other parts of the industry.

In the UK there is less need for change.The legal structure is sound and canaddress any change that is necessary.What does need to change dramaticallyis the Bank of England and theFinancial Services Authority rule book.This is too long and too detailed tomeet the needs of the market. A moveback to principles and objectives in

THE CREDIT QUAKE CONTINUED


22

‘Far too much regulatoryeffort globally has beenwasted looking at thingsthat, in retrospect, just donot seem to matter’

regulation would be much moreeffective. Rules that do not clearly addvalue to the overall objectives ofregulation should be abolished. Perhapsthe FSA could adopt an objective ofhalving the size of its rule book in ayear.

A better focussed series of rules andregulations would be far moreappropriate that the detailed analysisthat is currently in place.

We remain concerned that there will beknee jerk regulation in response to thecrisis. Without doubt any regulationpassed in haste will need to berepented at leisure. Putting additionalburdens on the banks at this stage willslow their recovery and deepenproblems in the economy generally.

This should be avoided.

There will be countless people callingfor additional disclosure and reportingfrom the banks. Much of this will bebased on the bizarre notion thatreporting would have made anydifference to the crisis. We take thefirm view that additional disclosure tothe markets is the least of the problemsthat we are currently facing.

Bank’s accounts are full of disclosure,much of it academic, such that theaccounts are already almost impossibleto decipher. Additional disclosure willmake them even harder to understandand the weakness of the press toanalyse such matters would actuallycause the next failure to be even worse.

Without doubt the main cause of the

current credit crisis was liquidity.However, from a regulatoryperspective, what we believe isrequired is not more disclosure, butbetter disclosure and here we takeissue with international accountingstandards. IAS39 in particular is one ofthe causes of the crisis effectivelyrequiring assets to go to fair valueregardless of the reason why they areheld. In our view it remains completelyincorrect to force a fair valueadjustment onto an asset which islikely to repay at full value.

The standard resulted in securitisedasset tranches no longer beingappropriate for exactly the reason thatthey were created. Without anyoneelse actually wanting the assets theresults were always going to beobvious – freefall of securitised assetprices. These are not toxic wastemortgages, purely an accountingstandard that has undermined an entiremarket.

Again too many people are aimingtheir fire at the wrong culprits.

6. The International AccountingStandards Board

The IASB needs to replace IAS39 as amatter of urgency. They also mustmake sure in future that theirtheoretical ideas are fully reviewed tounderstand practical impacts and alsothe law of unintended consequenceswhich clearly applied in this case.

7. The Banks

Enterprise Risk Management (ERM)must be the new mantra of all banks.Our views are that for too long manybanks have not really embedded riskmanagement fully into the way thatthey do business. The consequence isthat unexpected events cause them tohave unexpected problems. Theembedding of risk management suchthat all staff really understand theirroles within the Bank and how thatleads to ERM being achieved has notbeen done.

This will need major educationalprogrammes and changes to systemsand behaviour. Risk management willneed to be far more approachable andappreciable to all staff. It is not aregulatory construct, it is the way thatyou should do business to ensure thatyour institution survives.


23

As Risk Reward has been consistentlyreviewing the causes of the crisis (thisis well documented in previousupdates) in this update we look at thelessons from the past and their impacton the solutions for today.

It remains our belief that the actionsbeing taken are dealing with symptomsand are actually ignoring what we see asthe elephant in the room.

Globally we are seeing governmentsand central banks seeking to reduceinterest rates and increase publicspending to stimulate their economies.The question that everyone is nowconsidering is whether this will actuallyhave the desired results. Our views areclear. Since the actions do not deal inany way with the causes of the crisis,but with the symptoms, they willinevitably make matters significantlyworse.

Risk Reward has previously explainedthe crisis dates from 2003/4, not 2007,so any analysis that commences withthe latter date will be fundamentallyflawed. Further the crisis commencedwith concerns over asset securitisationand whether these assets, which haveno other significant acquirers, actually

can be suitable for the banking book offinancial institutions. This is a realproblem since the assets were designedto develop AAA rated assets for thebanking book to replace sovereignassets and thereby enhance the yield.

The Impact of Reducing InterestRatesBoth the UK and the USA have nowreduced interest rates below rates ofinflation. The consequences of this aremany:■ Anyone with deposits will feel worse

off. In real terms their deposits willdecline in value and they willconsequently wish to reduce theirconsumption to compensate. Sincefor every borrower there aretypically eight depositors, this has asignificant impact on marketconsumption.

■ Companies with significant cash willmove their deposits to higherinterest rate countries, therebyremoving liquidity from the bankingsector at exactly the time when it ismost required. Such countriesinclude the GCC, for example.

The reduction in interest rates has hada significant impact on the currenciesconcerned. In the case of sterling weare seeing a reduction of typically 30%

against a basket of currencies. Thishad to be expected. The problem

for a country like the UK whichimports a significantproportion of the goodsavailable for sale due to thelimited manufacturing base isthat it starts to importinflation. With commodities

priced in dollars (a 25%depreciation) and the remainder

experiencing 30% depreciation,cost inflation is certain to take offat exactly the time when people arefeeling times are tough.

Basically the governments havetaken a historic economic model that iseffective for an exporting country andapplied it to a country that is a netimporter. With regret this will haveexacerbated the problem as we will seelater.

Funding Large Scale ProjectsThe other issue has been whether

countries should commencelarge infrastructural projects

in an effort to stimulate the economy.The problem with such projects is thatthe type of work uses labour that tendsto come from overseas and thereforethere is a leakage of cash from theeconomy. Further these assets are oftennot income generative and aretherefore unable to increase the valueof the economy.

There is no evidence that a failure tobuild was actually the cause of thecrisis. Indeed there is a lot of concernat the level of borrowing within theeconomy. That bank borrowing is ineffect being replaced with governmentborrowing is one of the most surprisingoutcomes of this entire process. Wecannot see any way in which suchspending can in any way result in ashortening of the crisis – indeed we areconcerned that it may in effect extendthe process significantly.

The Actions that Were ActuallyRequiredPerversely perhaps we are of the viewthat increasing rather than reducinginterest rates would have assisted withsolving the issues that are of concern.Higher interest rates provide supportto the currency and reduce the price ofimports. At the same time there is areal rate of return if such rates arehigher than inflation, resulting in bothindividuals and firms placing greaterfunds on deposit at the banks. This inturn provides additional liquidity withinthe banking sector and enables thebanks to extend credit to other firms –effectively unlocking the credit impassewhich we are currently suffering.

One of the concerns that we have hadthroughout the crisis was the limitedexperience in their roles of many of theinternational global players during thiscrisis. This lack of experiencecombined with a similarity of outlookand an intention of dealing withsymptoms rather than problems hascompounded the situation.

It is our belief that eventually sensiblepeople will recognise the actions thatmust be taken that drives ourexpectations for next year. It is ourview that the actions taken on the UKeconomy will have extended recessionin the UK by at least six months andthat such a recession will be far deeperthan was in effect necessary.

RISK MANAGING THEELEPHANT IN THE ROOM


24

There is vocal demand for an increase in regulation to dealwith the last crisis. Of course that is always the problem –regulation developed to deal with the last crisis can oftenexacerbate the next crisis.

The first question to consider is whether there was in fact afailure of regulation, and if there was where was it? Previousupdates have considered the problems caused by SFAS 157and IAS 39, so these will not be repeated here. Clearly thereis limited back up for the minimum capital requirements for abank being 8%, with 10% being applied by some countries. Atthe heart of the issue regarding the appropriateness orotherwise of the regulatory structure is the question as to therole of capital. Historically it was designed to protect theindustry from a failure of one institution – in other wordswere one institution to fail then it would not cause the failureof another institution.

What appears to be being considered is some form ofprotection to deal with unlikely events, events that mightonly happen once in a hundred years, for example? Theproblem about that type of approach is that for ninety nineyears out of a hundred there will be a cost to the institution(the capital) whereas in the one year when it is required thecapital will be seen to be inadequate. The consequence of thisis that if capital cannot protect in normal conditions (whenlosses are budgeted for, so no capital is required) and it doesnot work in extreme conditions (when it can never beadequate), then the focus on capital as the measure of risk isprobably inappropriate.

We have also seen commentators recommending capital forliquidity risk, together with a requirement for additionalreserve lines. Since liquidity is actually the management ofcapital, providing capital for liquidity risk cannot make sense.We also doubt the value of reserve lines. In the case of amajor failure of an institution where significant sums are

required would you REALLY expect a bank to send $500m toa stricken competitor in the expectation that they will not getit back? Surely they would take the view that theadministrators could see them in court?

We have a lot of sympathy with the view that the role ofregulatory capital as a key measure of risk should bequestioned and wonder whether the focus on regulatorycapital has itself contributed to the crisis.

Our views remain that stress testing and scenario modellingare of paramount importance to an institution and should leadto action from the Board of the firm.

In 2009 we are expecting to see increased focus on liquidityrisk management particularly in the light of the Basel paperissued in November 2008. Since this is likely to be to thedetriment of other risk management within institutions, thenext crisis will be from a different source. We believe that thiswill be credit risk where firms utilising the standardisedapproach in countries where general provisions are notpermitted will have insufficient capital to deal with the lossesthat will actually occur. This is due to the standardised creditrisk calibration being based on a QIS undertaken by the BISin a benign credit environment. We would anticipate that allinstitutions on the standardised approach would nowcalculate a lower capital requirement that the equivalent bankusing the IRB.

We are also expecting to see a greater focus on enterprise riskmanagement due to the requirement for institutions tounderstand the totality of their risk environment on aconsistent basis. This will involve better and more consistentmodelling of risk appetite used as a driver of the riskprogramme within a firm, linked into stress testing, scenariomodelling and economic capital modelling.

WHAT NEXT FOR RISK MANAGEMENT?

It must be emphasised that these areour views on the next 12 months.These are not in any way a forecast thatshould be used for trading purposesand we always recommend that youshould take independent advice priorto making any investment decisions.We do not accept any responsibility forthe accuracy of the materials containedin this section. However many of youwill know that we have been quitesuccessful in previous years in readingthe market. Together we will see howwe do this year.

The real question is are we going tohave a downturn or a crash?

Interest RatesWhilst the short term pressures fromwhat we see as being incorrect

government intervention will driveinterest rates downward, perhaps to1%, this is unsustainable. Ourexpectation is that by the end of thefirst quarter of 2009 interest rates willhave started to rise. We anticipate thisto continue throughout 2009 and areextremely concerned at a potentialspike in rates during 2010. As at 31December 2009 we anticipate baserates in the UK being at 4.5% and areconcerned that they could double inthe following year.

US Dollar Exchange RatesThe unprecedented and unfunded USdeficit continues to grow with a seriesof promises being issued which the USgovernment in our view will be unableto finance long term. This is a serioussource of concern and will represent a

continual pressure onthe US dollar. We seecontinual weaknessagainst a basket ofinternationalcurrenciesincludingdepreciation overthe year of around15%. However therewill not be a majorchange in theexchange rateagainst sterlingas discussedbelow.

SterlingExchangeRatesThe UK

THE RISK REWARD 2009 PREDICTIONS


25

government borrowing is also at aunsustainable level and needs to betaken under control as a matter ofurgency. We cannot see any reason forsterling to strengthen against a basketof international currencies and expect afurther 20% depreciation. In terms ofthe dollar the rates will remain atroughly current levels due to thecombined weakness of both currencies.

The Oil PriceLast year we forecast that oil would fallwithin what we still consider to be itsnatural price band of $40-$60. We cansee no reason to change this expectationand therefore continue to believe thatthe oil price will continually strive tostay within this band. In the short termthe removal of the consumptionpressures from both the USA and alsoChina/India is having a significantimpact and will result in the oil pricecontinually stressing the bottom of therange. At 31 December 2009 a price ofaround $30 - $40 is to be expected.

Property PricesProperty is falling throughout much ofthe world. Whether you areconsidering commercial property inDubai or residential property in theUK there is nothing that we can seethat should cause property prices torise. The development of infrastructuralinvestments increases the costs ofbuilding and the lowering expectationsof both companies and people willcontinue to cause problems forproperty. Our expectations are areduction in UK property of 10%-15%and for UK commercial property of20%-30%. In the case of retail spacethe fall will be higher – perhaps 35%.

In the US falls will continue, but weexpect the largest falls globally to be inDubai where a 40% fall in commercialproperty due to the absence of demandis to be expected.

Stock MarketsAgain there is no reason for muchoptimism. The lack of trust that is

compounded by recent public failureswill continue to represent a drag on themarkets for the foreseeable future. Wedo not expect a significant reboundduring 2009 with markets rising byperhaps only 5% over the entire year.

Bond MarketsThe place where you will not want tobe in 2009 is in our opinion fixed ratesecurities. Since interest rates areapproaching their bottom you canexpect to see fixed rate securitiesstarting to fall. During 2009 a fall invalue of perhaps 20% is to be expectedon a global basis.

CommoditiesAs you will have noted we are not veryoptimistic about assets in general.Some of the brighter spots will be inphysical commodities, particularlyfoodstuffs, which will retain currentprices and could experience a smalllevel of growth. Not spectacular but atleast they may represent a safe haven intimes of stress.

THE RISK REWARD 2009 PREDICTIONS CONTINUED

A Ponzi scheme isa technique usedby fraudsterswhere theoperator of thescheme promiseshigh return toinvestors in short-periods but makesno actualinvestments at all.Instead, theoperator will usemoney fromfuture investors toshow previousinvestors that aprofit has been

made, paying out sums that actuallyhave not been earned. The scheme iscompletely reliant upon money comingin from new investors to continue to payout the returns to existing investors.Effectively the investors who withdrawtheir funds are actually defrauding thenew investors. If the flow of money from

new investors ceases, so does that Ponzischeme.

The scheme is named after CharlesPonzi who in 1919 conducted a schemeinvolving the buying and selling ofinternational mail coupons. Hepromised investors a forty percentreturn in just ninety days. The prospectof high returns within a relatively shortperiod of time is all a part of theattraction that comes with Ponzischemes. Ponzi was able to take in $1million within just a three-hour period in1921. It emerged that he had only infact purchased $30 worth of mailcoupons.

A Ponzi scheme is different to aPyramid scheme in two significantways.

Firstly, a Pyramid involves paymentsbeing made to an investor on the nextlevel up. In a Ponzi scheme, money ispaid directly to the operator of the

scheme. Furthermore, the latter canonly be sustained by current investorscontinuously recruiting new investors. APonzi scheme does not require newinvestors necessarily, provided that theoperator of it can persuade an existinginvestor to reinvest his ‘profits’. It isonly when the investor withdraws fundsthat the scheme actually fails.

So the question is how can you identifya potential Ponzi scheme? In the typicalscheme returns are higher than themarket and normally higher than couldbe realistically expected from the natureof the activity being conducted. Theseller of the investment vehicle is highlycredible and normally well connected,such that the regulatory structure eitherdoes not apply or loosely applies to thefund.

Finally always remember that ifsomething looks too good to be truethen it normally is too good to betrue!

PONZI SCHEMESIN THE LIGHT OF CURRENT NEWS PONZI SCHEMES ARE BACK IN THENEWS, THE QUESTION YOU MAY BE WONDERING IS WHAT ACTUALLY APONZI SCHEME IS AND WHO WAS CHARLES PONZI?


26

Q: Is there a requirement for anew regulator to considerinternational bank regulation?

A: This question is being posed bypoliticians internationally. Of courseanyone involved with the bankingindustry will know that regulatoryrequirements are set internationally bythe Bank for International Settlements.This is a committee of central bankgovernors tasked with devising suitableglobal banking regulation.

They have developed the propositionof the Home and Host regulator. TheHome regulator is the regulator of thehead office and works with a college ofregulators (Host regulators) to regulatethe international business. One of thestrange results of the current crisis ishearing politicians, notably in the UK,recommending the structure thatalready exists. The real issue is whetherthe Bank for International Settlements(BIS), based in Basel in Switzerland,has a sufficiently broad remit and theright membership. Since itsmembership has remained fixed in apost second world war mindset, wewould argue that it is not representativeof the global banking community.

We would also suggest that central bankgovernors alone should not beresponsible for bank regulation and thatother BIS stakeholders should also beinvolved. The current structure enablestheoretical solutions to be applied whichmay have unfortunate side effects.

Further the BIS are focussed on bankregulation. This crisis has shown thatthe financial industry operates as oneconsolidated body including assetmanagers, insurers, brokers and hedgefunds. Accordingly we wouldrecommend extending the scope of theBIS to include the whole industryrather than solely banking.

Q: Is more capital the answer forthe banking industry?

A: The original rules that came up withthe capital requirements of 8% are nowrather old and do not stand up toscrutiny. Some countries actually apply10% already – but that then leads tothe questions as to the objective ofcapital maintenance.

If capital is to deal with unexpectedevents, then most of the time it will notbe required. Expected losses are dealtwith best through robust budgetingand pricing strategies and therefore it isunexpected loss that is dealt withthrough capital. But an averaging styleof calculation to deal with events thathappen on average can never workeffectively. In terms of an unexpectedevent it will either happen or it will not.One fiftieth of an event will nothappen. Effectively the answer is binary– yes or no.

That means that the capital held willprobably never be sufficient to dealwith extreme unexpected events –which is why it is held in the first place.To get institutions to hold themaximum capital would put a coststructure in place which would ruin theglobal economy for the foreseeablefuture.

Accordingly we have great concerns atthe focus on bank capital as being thesolution and recommend that insteadbanks should focus on improved stresstesting and scenario modelling.

Q: Are zero interest rates goodfor an economy?

A: If an economy is a net exporter weview low interest rates as good. Thedeclining currency enables an exporterto grow their markets at the expense oflocal incumbents. This creates growthin the economy, leading to improvedemployment and increased revenues forthe relevant government. If theeconomy is a net importer however,low interest rates are a disaster. Thecollapse in the currency leads toimported inflation, increasing pressureon local standards of living. Perceivedinflation (the inflation felt by people) ishigher than actual inflation and thendrives wage inflation.

This is combined with a collapse ofgovernment revenue and thewithdrawal of industry cash depositsfrom the banking system. The build upof inflation in the economy forces achange in economic policy byincreasing interest rates at the wrongpoint of the cycle causing massiveunemployment. Our concern is thatgovernments are using policies suitablefor an exporting country to address the

problems of a net importing economy.Such action will generally increase theferocity and length of the recession inthose counties.

Q: What are the Long TermProspects for the BankingIndustry?

A: This is an issue that we will comeback to in future Updates. Our answerto this is that at the end of the crisisthere will be a banking industry, but themajor players may well be significantlydifferent from those at the start of thecrisis. Many of the major players willhave either gone altogether orsignificantly reduced in size. New typesof firm will emerge and they are likelyto offer different types of service thanhad previously been the case. Theresulting industry may initially besmaller than the industry before thecrisis, but you can expect growth tocommence almost immediately again.In twenty years a new industry ofcomparable size with comparableglobal players will emerge. In terms ofthe five year view, it is hard to beoptimistic. Much of the global actionthat has taken place has in our viewbeen misguided and exacerbated adifficult situation. It will probably takeup to ten years for all of these issues towork through the financial markets,with the borrowing and fundingstructures representing a long termdrag on the economy. What we doexpect for new types of ethicaltransparent instruments to evolve thatbetter meet the demands of thecustomer base whilst adding value tothe international community.

FREQUENTLY ASKED QUESTIONSIN THIS SECTION WE ADDRESS A SERIES OF QUESTIONS RECENTLYASKED AT RISK REWARD TRAINING EVENTS AROUND THE WORLD:


27

On December 4, 2008 the Securities and ExchangeCommission (SEC) approved a series of measures to improvethe transparency and accountability of rating agencies. Theimportance of this pronouncement is of significance to theglobal community since the major ratings agencies all have aUS base and are therefore required to comply with these

regulations.

These proposals were issuedfor responses within 45 days.Amongst the changes was thefollowing:

“(the rules ) would prohibitan (agency) from issuing acredit rating with respect toan obligor or security

where the (agency) or an affiliate of the (agency) maderecommendations to the obligor or the issuer,underwriter, or sponsor of the security about thecorporate or legal structure, assets,liabilities, or activities of the obligoror issuer of the security.”

The structure of the industry has alwaysbeen a cause for concern to many of us.

Ratingsare paidfor by the company that israted, therefore ratingsagencies actually go aboutselling ratings. If a companyreceives a rating that theyconsider inappropriate thenthere must be a tendency forthem to wish to surrendertheir ratings. This has beenexacerbated by the BaselAccord where banks lendingto firms that are unratedreceive a lower capital chargethan those lending to firmswith poor credit ratings. Thesurrender of the rating resultsin a lower capital charge forthe bank and also therefore alower interestcharge to thefirm.

The ratingsagencies also havesignificantbusinessesinvolved with the

provision of various consultancy style services. In credit riskMoody’s KMV is one of the market leading credit riskproducts, whereas Fitch owns Algorithmics, Opvantage andFitch First; all risk products. The combination of these withconsultancy arms means that the ratings agencies are

providing ratings to financial institutions where they have alsoprovided guidance on the risk management techniques thatthey should employ.

We do not at this stage believe that such activities will beexpressly prohibited by the SEC. However, we do remainconcerned that the provision of such services does create theperception of bias in ratings subsequently provided. Indeedmore than one of the ratings agencies has stated that they willreward firms that have appropriate risk management systemswith higher ratings.

The situation parallels the notion that previously existed withthe accountancy practices where there had been concern atsuch firms providing consultancy services to those firms towhich they provide external audit services. This resultedinitially in an effective prohibition of the provision of suchservices, although these rules have now been relaxed.

The industry has a difficult conundrum to deal with. Themarket needsratingsagencies thatareindependentand alsoneeds themto look at

issues from a series of different perspectives. Anything thatcreates a potential for bias within such a system is to beabhorred, yet both the ways that the ratings are paid for andthe provision of additional services provides the perceptionthat such bias might potentially exist. The alternative is ratherdraconian and would require a central levy to fund theprovision of ratings by quasi-governmental agencies thatcannot provide any other services. We have real concernswhether such an agency would either be effective orsufficiently accountable.

We would also welcome the development of a new ratingscompetitor with a non-US perspective to form some levelof balance to the existing market participants.

Whether any real progress in these areas will occur is subjectto doubt, but the natural imbalance in the industry will remaina cause for concern. What we do expect is for the ratings

agencies tocontinue tocome undergreater scrutinyand for them toreduce thenumber andrange of servicesoffered to

clients that they rate. Our concern is that this mightundermine the profitability of the ratings agencies potentiallyresulting in one of the firm becoming a pure consultancy playand giving up the ratings business altogether. This once againwould be the law of unintended consequences applying.

THE PROBLEM WITHRATING AGENCIES


28

The combination ofthese withconsultancy armsmeans that the ratingsagencies are providingratings to financialinstitutions wherethey have alsoprovided guidance onthe risk managementtechniques that theyshould employ

The key issues that they have raised arethe following:

■ Tax havens■ Bank secrecy■ Bank regulation■ The Financial Stability Board

There is very little new in any of thesepronouncements. The concern that youwill be having is whether this willactually work in practice. Our view isthat the current discussions, were theyto lead to new regulations, wouldcertainly provide no benefit and couldactually harm further the globaleconomy.

Tax HavensFirstly tax havens. G20 governmentshave concluded that these are badthings. This is nothing whatsoever to dowith the financial crisis, rather it isabout the G20 trying to use theirweight to stop smaller countries earningincome through offering low cost andlow taxation environments. Of coursesome of the best low tax environmentsare actually on shore, not offshore; withperhaps the Dublin free zone being atypical example. This is purely a grabfor tax revenue and nothing to do withthe current financial crisis.

Bank SecrecyWe are seeing pressure on manyjurisdictions, including Switzerland andLuxembourg, to provide furtherinformation on their customers. Theobjective is once again to reduce taxleakage from G20 countries and toassist money laundering deterrenceefforts. This is a relatively pointlessgesture that will result in a lot ofdiscussion, but very little value. Moneylaundering will not reduce unless crimereduces and there is little evidence ofthat. We are in the process of issuing anew book on Money Laundering (notmoney laundering deterrence) to bepublished by Wiley in the summerwhich will consider this issue in moredetail.

The Financial Stability BoardThe Financial Stability Forum is part of

the Bank for International Settlementsstructure and has previously issuedpapers which are more academic intheir outlook. It has been great forresearch papers and the developmentof ideas. Is it the right place to look atcontagion within the financial sector?We would suggest that is not right.

The Bank for International Settlementsis a committee made up of central bankgovernors of the G10 with a few addedmembers. By passing this responsibilityto the Financial Stability Forum andrenaming it the Financial StabilityBoard the G20 is again making surethat they have the key controls overthe issue. Basically smaller institutionsare excluded.

The solution should have been tocreate a forum within the InternationalMonetary Fund, probably using thealready existing Institute forInternational Finance. This is a globalgrouping which includes elements fromall areas of interest in the financial

community, including governments andbanks. Surely that is a better forum fordiscussion.

Bank RegulationThe current discussions seem to besuggesting a “back to the 1950s”approach to banking. What we wouldlike to say to the G20 is “Well if you allwant to go bankrupt, go ahead.” Put atits simplest, for every £1 reduction inthe borrowing by a bank, you add £2 tothe borrowing by a government. Thissimple adage has been made very clearin the current crisis.

The Role of CapitalThere are so many issues with currentregulation that need to be addressed,that they have failed to do so is perhapsdisappointing. A single concern is therole of capital itself. What is capitalactually for? We seem to spendenormous amounts of time discussingthat this bank or that bank has a capitalratio which is below the marketexpectation – but what does it mean?

THE G20 RESPONSE -THE FUTURE OF FINANCIALSERVICES REGULATIONSO THE G20 HAS MET AND LOOKED INTO THE ABYSS OF THEFINANCIAL CRISIS AND COME UP WITH… VERY LITTLE


29

The logic for capital maintenance hasalways been that it is to protect themarket from a failure of a bank in timesof stress. Effectively it is a fund tocover a rainy day. Guess what – it is notjust raining, there is a storm outside.Surely if capital has any use at all itshould be being used at present? Thatmeans that in times of stress, capitalrequirements should be reduced.They would then be built up againduring the good times to cover thefuture expectations of disaster. It wouldsuggest a cyclicality to regulatorycapital which is not there at present.

The Regulations ThemselvesWere the regulations the cause of thecrisis? Actually the focus in the BaselAccord on credit risk and operationalrisk, with no changes to the massivelyinappropriate market risk rules, didtake the eye of management away fromcertain risks that really matter. We havesaid in previous Risk Updates goingback many years that we wereconcerned that banks were notprioritising the modelling of liquidityrisk. This was in part due to theregulations not requiring suchmovement, but also due to theavailability of liquidity being such thatnobody really worried.

What we do need is for a regulatory

regime that actually is consistent andlogical. We do not need more rules,we need better rules. All of the riskassessments required by the Bank forInternational Settlements should be

directed at ensuring a bank knows whatthe risk might be if certain plausibleevents were to occur in the future.There should never be a capitalrequirement for anything that abusiness budgets for. That is justillogical – if a risk is addressed inproduct pricing then it does not needto be included in a capital charge.

The rules need to be consistent and allto the same confidence level. Nolonger should the market accept acombination of 99.9%, 99% and 96% asbeing acceptable. Actually werecommend abolishing all of the riskcommittees at the BIS and replacingthem with a single risk grouping thatwill deal with all risk issues. This willhopefully result in a consistent andintellectually valid approach toregulation. Of course there is nointellectual rigour regarding theminimum capital rules of 8% and thereis no evidence that expected losses canbe used to infer unexpected or unlikelylosses; so there is actually rather a lotto do.

We are firmly in the camp that believesprinciples-based regulation is the onlyapproach that is effective.

If the regulators end up trying to go fordetailed rules, this effectively results inregulators and governments trying torun banks, and with regret that can onlyend in tears. Just look at what thegovernments are actually doing atpresent – can much of it make sense? Ifthe crisis was caused by problems ofliquidity and rules requiring assets tobe priced to a market value whichmassively understates inherent value,then these are the issues you need todeal with. There is no evidence thatthis was understood by the G20.

The Role of Non-ExecutiveDirectorsSeparately we have seen thoughts thatnon-executive directors should be in aposition to question managementappropriately. Clearly risk specialistsare the ideal candidates for such rolesand we think that this is a usefuladdition to the debate. As a firm wepossess access to one of the largestgroups of experienced risk professionalin the world and anticipate receivingregular requests for non-executivedirectors. Our risk specialists all havemore than 20 years of relevantexperience and can add significantvalue to the Board discussions at anyfinancial institution.

THE G20 RESPONSE – THE FUTURE OF FINANCIAL SERVICES REGULATION CONTINUED


30

...the focus in theBasel Accord oncredit risk andoperational risk,with no changes tothe massivelyinappropriatemarket risk rules,did take the eye ofmanagement awayfrom certain risksthat really matter.

On 8 April 2009 The Committee ofEuropean Banking Supervisors (CEBS)issued a consultation paper (CP24) onHigh Level Principles For RiskManagement. According to thisanalysis, “EU and internationalsupervisory bodies have produced acomprehensive set of guidelinescovering all aspects of riskmanagement”. You may well disagreewith this statement, since our view isthat such principles are inconsistentand incomplete. The CEBS does statethat “the coverage of the guidelines issomewhat fragmented”. They also notethat CEBS’ guidelines have gaps in thefollowing areas:

■ Governance and risk culture■ Risk appetite and risk tolerance■ The role of the Chief Risk Officer

and risk management functions■ Risk models and the integration of

risk management areas■ New product approval policy and

process

The CEBS has consolidated all of itsprinciples and guidelines addressingrisk management into a comprehensiveguidebook.

CEBS state that these high-levelprinciples proposed in CP24 should beconsidered both by institutions andsupervisors within the supervisoryreview framework under Pillar 2 (i.e.the ICAAP).

Whilst these principles are aimedmostly at large and complexinstitutions, they can be adapted to anyinstitution under review, taking intoaccount its size, nature and complexity.

The High Level PrinciplesThese fall under the same headings setout above. In this brief article we onlyset out a few issues of specific interest.For the full information, referenceshould be made to the originaldocument.

Governance and Risk CultureThey require a comprehensive andindependent risk management functionunder direct responsibility of the seniormanagement. They also require thatthe management body have a fullunderstanding of the nature of thebusiness and its associated risks.Specifically they are looking for senior

management with capital marketsexperience, although the key from ourperspective is for the non-executivedirectors to be in a position toadequately challenge risk management.

They require that every member of theorganisation must be constantly awareof his responsibilities relating to theidentification and reporting of risks andthat a consistent risk culture must beimplemented, supported byappropriate communication.

Risk Appetite and Risk ToleranceCEBS state that risk tolerance shouldtake account of all risks, including offbalance sheet risks. Then the paperrequires management focus onconsistency of targets, withresponsibility residing with themanagement body and seniormanagement.

In our opinion there is much confusionsurrounding risk appetite and riskappetite modelling and it is perhapsdisappointing that this paper does notreally add any clarity to the issue. Riskappetite in our view is a single metricthat is then converted into a series ofmeasures as appropriate, drivingbehaviour and control systemsappropriately. We are seeing manyinstallations that are impossible toeither use in practice or fail to addvalue to their institutions - and thesolutions are having to be changed andsimplified significantly. A little moreclarity of thinking would be ofassistance here. The remainder of thissection repeats wording from the Bankfor International Settlements (BIS)Sound Practices paper from 2003.

The Role of the Chief RiskOfficer and the RiskManagementFunctionBasically thereneeds to be apersonresponsible forthe riskmanagementfunction across theentire organisation– and this means allrisk types. They need tohave sufficientindependence and seniority tochallenge (and potentially veto) the

decision-making process and possessthe expertise that matches theinstitution’s risk profile. From ourexperience many of the CRO roles donot have this level of authority. Further,the professionalisation of the riskmanagement function is at a relativelyearly stage of development; so manyrisk professionals are only comfortablein certain risk areas. Perhaps they reallyunderstand credit risk, but notoperational risk. Perhaps they originallycommenced in market and liquidityrisk, but counterparty credit risk isbeyond them. As an enterprise riskmanagement firm we recognise boththe challenge and the opportunitiesthat a developing ERM framework andCRO can provide to any firm.

Importantly CEBS state that riskmanagement should not be confined tothe risk management function, since itneeds to be in the business. Perhapsthis is one of the failings of certainfunctions we have seen, where the riskprofessionals have undertakensignificant assignments without thebusiness actually being impacted. This

NEW HIGH LEVEL PRINCIPLES FORRISK MANAGEMENT


31

has to be the wrong approach since riskmanagement facilitates theimplementation of policies andprocedures, rather than actuallyundertaking the primary transactionsitself.

Risk Models and Integration of Risk Management AreasCP24 requires firms to identify andmanage all risks whilst avoiding over-reliance on any specific riskmethodology or model. Therequirement for a risk register wouldtherefore appear obvious and we wouldsuggest that this should be clearlylinked to the control framework andrisk appetite. These concerns over riskmodels have surfaced before, beingprominent in the 2008 Banana Skinssurvey promulgated by the CSFI(Centre for the Study of Financial

Innovation). CEBS raises concerns overthe conceptual limitation of metricsand models, highlighting the need forqualitative and quantitative data to becombined, with stress tests beingconsidered. This also provides manyfirms with a challenge related to thenatural inaccuracy of much of themodelling that is conducted. Thisshould not concern banks unduly sincemuch of this data is actually requiredfor strategic risk management asopposed to tactical risk managementand accordingly the same level ofaccuracy is not necessary.

New Product Approval Policyand ProcessThere is nothing much in this sectionapart from a requirement for a newproduct approval policy and newproduct due diligence.

ConclusionI am sure we will not be alone inthinking that the CEBS could haveprovided more useful guidance in suchan important area. It is perhaps theissues that they have failed to address -in particular the development of anenterprise risk management frameworkand the role of the non-executivedirector - that provide us with thegreatest disappointment.

There are however a few key messages,perhaps the loudest of which is thatrisk management is now central tothe way that a institution operatesand can no longer be relegated to amore junior level. The elevation ofrisk management as a principal drivermust be welcomed and the CEBStherefore generally applauded for theiradded impetus.

NEW HIGH LEVEL PRINCIPLES FOR RISK MANAGEMENT CONTINUED

Asset Management is a core Financial Services industryfunction but with its own unique demands, challenges andspecialisms. We recognise that many of the issues andtechniques required to manage and control ‘Buy-Side’ AssetManagement businesses are different to other financialbusinesses.

Accordingly, we have designed a range of services to supportAsset Managers. These are offered to:-

■ Those working within Asset Management businesses, and for

■ Those for whom Asset Management may be part of theirwider remit or responsibility (including IndependentDirectors, Business Managers and Controllers, Risk, Auditand Compliance professionals).

We also offer dedicated courses and advise those who employasset managers such as Pension Fund Trustees andInstitutional Investors.

TrainingRisk Reward offers a wide range of services specially tailoredto Asset Managers including the following courses and in-house training:-

■ Asset Management for Professionals■ Asset Management for Institutional Customers and

Pension Fund Trustees

■ Financial Investments andMarkets

■ Operational RiskManagement forAsset Managers

■ ICAAPPreparationand Review

■ RiskAssessmentReviews

■ Auditing AssetManagers

■ Asset Managementfor Independent or Non-Executive Directors

ConsultancyRisk Reward provides support, consultancy and co-sourcingservices for Asset Managers including the following:-

■ Design and development of a 21st Century RiskDepartment for Asset Managers

■ Corporate Governance and Controls for Asset Managers■ Re-organisations and Restructuring■ Mergers and Acquisitions■ Regulatory Inspection Visit Preparation

ASSET MANAGEMENT SOLUTIONS: FORTHOSE LEFT HOLDING THE (MONEY) BAGTHE ‘CREDIT CRUNCH’ HAS BROUGHT NEW CHALLENGES TO THE ASSETMANAGEMENT INDUSTRY RESULTING IN MANY PARTICIPANTS FUNDAMENTALLYREVIEWING THEIR BUSINESS MODELS AND PRODUCT OFFERINGS. ASSET MANAGERSARE FOCUSING ON THE FUTURE CHALLENGES AND THEIR REAL, AS OPPOSED TOTHEORETICAL, RESILIENCE TO COPE WITH EXTREME OR UNEXPECTED EVENTS.


32

What is the Turner Report?Lord Adair Turner, Chairman of theFSA, has recently published his muchheralded report on the credit crisis. Heexamines in sometimes tedious detailthe causes of the failures leading to thecrisis and then sets out hisrecommendations for the future.

It is worth noting that the UK’s FSA isthe first major regulator to publish sucha detailed report although its releasejust before the G20 Summit in Londonmay be seen as both timely and pre-emptive. Some might argue that itactually was presumptuous. It is clearthat Lord Turner and the FSA arehoping that their proposals will be bothtaken up in the UK and internationally.Many of the changes recommended byTurner go to the heart of the BaselAccord and impact on the internationalregulatory and supervisory frameworks.

Indeed, given the international andglobal nature of so many of the keymarket participants, really effectiveregulation can only work if it isimplemented across each of the keyfinancial jurisdictions on a consistentbasis. Only by achieving this canregulatory arbitrage be avoided.

Turner’s View of the Causes ofthe CrisisTurner identifies three underlyingcauses of the crisis:-

■ Macro-Economic Imbalances■ Financial Innovation is ‘of little

social value’ and■ Important Deficiencies in Key Bank

Capital and Liquidity Regulations

These, Lord Turner says, wereunderpinned by an exaggerated faith inrational and self-correcting markets. Hemakes an obvious observation instressing the importance of regulationand supervision being based on asystem-wide "macro-prudential"approach rather than merely focusingsolely on specific firms.

Readers of previous Risk Updates willknow that the first two issues wereactually nothing to do with the crisisand to blame them in our opinionsuggests faulty analysis working froman invalid hindsight perspective. Given

that we disagree with theanalysis conducted by LordTurner, it is perhapsunsurprising that we havereservations about hisrecommendations.

In his report Lord Turneradded that "The financialcrisis has challenged theintellectual assumptions onwhich previous regulatoryapproaches were largelybuilt, and in particular thetheory of rational and self-correcting markets. Muchfinancial innovation hasproved of little value, andmarket discipline ofindividual bank strategieshas often provedineffective”.

He identified the “faultlines in the regulatoryapproach”, due to the globalisation ofbanking activities, which led to “globalfinance without global government”.This is an issue that has beenrecognised for many years and appearswithin the Basel Sound Practices paperfrom 2003. Indeed the Basel Accordand subsequent papers were specificallydesigned to deal with such matters.However, was Northern Rock reallycaught because it was a globalinstitution? What about Fannie Mae orFreddie Mac? Almost all of theinstitutions that had difficulties – thesewere problems of liquidity notproblems of international regulation.

Unsurprisingly Turner calls for moreand improved regulation supported bya more intrusive approach bysupervisors and the end of ‘light touch’regulation. Whether a more heavyhanded rules based approach would bemore effective is not necessarily anautomatic consequence - as the SEChas demonstrated so very recently. It isclear to us that the detailed rulesapproach – which actually has beenfollowed by the FSA and otherregulators (specifically those adoptingGermanic approaches) – does notwork. The focus on detailed pointlessrules stifles innovation and preventsbanks from appropriately managingtheir business. Worse than that, the

regulators stop focusing on what reallymatters and instead look towards deathby a thousand cuts. It never happens.

The Turner ProposalsLord Turner proposes major reforms inthe regulation of the European bankingmarket, creating a new Europeanregulatory authority together withincreased national powers to constrainrisky cross-border activity. In our viewthis is will be a challenge to makehappen due to the problems of nationalrules and the certain disagreement as towhere it should be housed. The threatcould of course lead to someinstitutions leaving Europe, whichwould hardly be in anyone’s interest.

Similarly predictable, Turner proposesmajor increases in regulatory capital tolevels ‘significantly above existing Baselrules’. He does not really justify thisbecause it cannot be justified. Theproblem that the banks faced was afailure of liquidity, not a failure ofcapital. Northern Rock did not run outof capital – it just could not get theliquidity it needed at any price it couldafford. Lord Turner also calls for afundamental review of the trading bookcapital regime not just with a view toincreasing capital ‘by several times’ butto addressing the shortcomings of thecurrent VaR approach. Our view is the

THE TURNER REPORT REVIEWED -THE FSA’S RESPONSE TO THECREDIT CRISIS


33

current VaR regime is a problem anddoes need to be addressed, butwhether capital is the answer is open todebate.

This would, of course, affect banks’profitability and, particularly in thecurrent climate, would have a strong

political impacttoo since itwould reducebanks’ ability toprovide credit,which in turnwill impacteconomicgrowth. What isclear is thateverything thatTurner isrecommendingwill have theeffect ofensuring thatthe recession islonger anddeeper thanwouldotherwise bethe case.

Morecontroversially, he recommendscounter-cyclical capital buffers, to bebuilt up in good economic times sothat they can be drawn on indownturns. As mentioned earlier, this issomething that we agree with.

What Turner Did NotRecommendInterestingly, there are several areaswhere recommendations were expectedbut were not made in Lord Turner’srecommendations.

1. Turner has rejected the idea of aGlass Steagall separation of bankingand securities businesses as beingimpractical.

2. Contrary to many expectationsTurner has not called for a majorreview of or changes to theAccounting Standards which somany felt were at the heart of theproblems leading to the creditcrunch.

3. Similarly Turner highlights areaswhere he believes it is premature torecommend specific action, butwhere wide-ranging options need tobe debated. These include productregulation in retail (e.g. mortgage)and wholesale (e.g. CDS) markets.

4. While Hedge Funds might expectsome greater interest fromsupervisors Turner did not call forwholesale new regulation for them.

Really the accounting rules are notwithin the remit of the FSA, whichcould be the only reason for Turner tokeep clear. Were hedge funds the causeof the crisis? Was it derivatives? It isour belief that derivatives have beenthe savior of the global financialservices industry this time and, hadthey not been available, currency wouldhave failed by this stage.

Dumb or Dumber?However, amongst his other proposals,Lord Turner has recommended anumber of specific changes, includingthe following:

■ Regulation of “shadow banking”activities on the basis of economicsubstance not legal form: increasedreporting requirements forunregulated financial institutionssuch as hedge funds, and regulatorypowers to extend capital regulation;

■ Regulation of Credit RatingAgencies to limit conflicts ofinterest and inappropriateapplication of rating techniques;

■ National and international action toensure that remuneration policiesare designed to discourage excessiverisk-taking;

■ For the UK he also proposes majorchanges in the FSA’ssupervisory approach,building on the existingSupervisoryEnhancementProgramme, with a focuson business strategiesand system wide risks,rather than internalprocesses and structures.

Was shadow banking atthe heart of the crisis?Not really – where is theevidence to support such anincrease in costs? Theratings agency issue needsto be covered much morecarefully and is an issue weshall return to. If Lord Turner’ssuggestions are taken into account thiswill probably result in the demise of theratings agencies as businesses. Basicallythe increased costs will result in anunexciting volume business becomingunprofitable and we would suggest thatsome or all will close. Now that wouldreally be an achievement for Turner totake to his grave.

The report also calls for improved riskmanagement and governance and theup-skilling of the regulator’s own staff.As one of the causes for the crunch,Turner refers to a ‘misplaced reliance

on sophisticated maths’ which made it‘increasingly difficult for topmanagement and boards to assess andexercise judgment over the risks beingtaken’. We have much sympathy withthis point of view and do consider thatmisplaced reliance on inaccuratemodelling is a problem. However onceagain Lord Turner must be stoppedfrom throwing the baby out with thebath water. What we need is bettermodelling and better trained boards,perhaps including non-executive riskspecialists. What we do not need isprejudiced ignorance.

Perhaps, with all the change and freshthinking that is now being debated, itmight be sensible for regulators andbankers alike to reflect carefully on theenormous reliance we do place onmodels and statistics to the exclusionof good old fashioned common sense.The Accord itself sets very clearobjectives for any model – how often itshould be tested and validated and theimportance of understandingassumptions. The rules are alreadythere – they just need to be applied inpractice.

What will be interesting is to see howthe global regulators agree or disagree

to proceed. There was the appearanceof broad agreement at the April G20meeting in London. However whenwe move from the discussion stage tothe ‘development’ and‘implementation’ stages will theapproach really be a united andintegrated one or will it be local and,dare we say, protectionist. Let us hopethat the Turner report is not theblueprint that he hopes it is. We donot believe it is the answer to theproblems of the current world and alsoare concerned that the next crisis canbe seen in the inappropriate responsesbeing suggested to this one!

THE TURNER REPORT REVIEWED CONTINUED


34

‘If Lord Turner’ssuggestions aretaken intoaccount this willprobably result inthe demise of theratings agenciesas businesses. ‘

What we need is bettermodelling and bettertrained boards, perhapsincluding non-executiverisk specialists. What wedo not need is prejudicedignorance

The extreme volatility combinedwith the dramatic value declines inthe vast majority of asset classes overthe past 12 months has stunned evenseasoned investors. Further, the(originally) disjointed and separatistpronouncements by Governmentsand regulatory authorities followingthe collapse of the financial marketsonly increased uncertainty and hasled to a concerted drive towardsboth cash and the most secure ofinvestments, notably US TreasuryBills and gold.

The investment community isbeginning to emerge (although verybattered and bruised) from out of theglare of the headlights to plan the pathahead. But what path and to where arewe heading? If nothing else, the marketcorrection has acted as a catalyst and inmany cases has stimulated investors toadopt a “clean sheet approach” toformulate a plan for going forward.

A comprehensive investment strategycovers a multitude of areas includingfor example, asset selection andallocation, timing, investment risk,capital risk, currency risk, liquidity riskand (in many instances) reputationalrisk. These areas on their own can becomplex and contain sub-areas thatcould be the subject of lengthy articleson their own. However, the aim of thisarticle is to stimulate some lateralthought on a clean sheet basis toindicate how one can refine a searchdown to select targeted investmentareas.

Where to Start?But first, how can one describe aninvestment? In our experience therationale behind the purchase ofinvestment assets can broadly fall intoone of two categories– (I) those assetsthat are purchased on the belief thatthey can be sold in the future tosomeone else at a higher price; or (ii)those assets that it is believed willaccrete in value over time (throughcapital appreciation and/or income).Obviously many assets fit into either orboth categories – but it is theinvestor’s rationale (or attitude) behindthe purchase that is the segregator, notthe asset itself.

Some investors pay great attention tothe economic cycle and select androtate their investments depending ontheir views of the current positionwithin a cycle and its length andstrength. For example cyclical stockssuch as steel manufacturers and steelstock holders are the classic early cycleout-performers, but are relativelyunattractive later on as the cycledevelops.

Another early cyclical play is thegeneral retail sector and, as an example,look at the graph below of the Marks &Spencer PLC share price. For manymarket participants it may come as asurprise that the current share price isactually above the level of July last year- i.e. before the dramatic collapse ininvestor sentiment following the failureof Lehmans. Further, despite thecompany recently announcing a fall insales of over 4%, the shares have risenby more than 50% from their lows inNovember – a classic example of themarkets looking through the worst ofthe downturn and anticipating theeconomic recovery after a recession.

However, in this article, rather thanengage in the merits or otherwise ofsector and specific stock selection, weshall explore briefly some thoughtprocesses behind a few long-terminvestments ideas. We will leave therelated questions such as assetallocation and risk mitigation to laterarticles.

Fundamental ResearchFundamental top-down research canidentify major discernable trends thatcan indicate areas where investors canconcentrate their efforts to uncover

attractiveinvestmentopportunities.The following arethree discreteexamplesselectedspecifically todemonstratethe breadththat freethinking canlead to.

Nuclear Power &ThoriumSince the Chernobylincident in 1986,the paucity ofcommissioningnew powerstations has led toa sharpslowdown andvirtualstagnation ofglobal nuclearpower generation. There were 340nuclear power stations in operation in

1987, which grewto 438 in 2002 asplants underconstruction cameon line (with Japan,S. Korea, India,China, Franceaccounting for 62of these) andcurrently number436. Of these, 339are over 20 yearsold with 127 ofthese over 30 yearsold – which is verysignificant

considering the 40 year standardoperating license period.

With world electricity demand forecastto double by the early 2030s - and bywhich time all bar 72 of the existingnuclear power stations will have passedtheir 40th anniversary – nuclear poweralone has the ability to satisfy thisdemand without the negative impact ofcarbon emissions. This process hasalready commenced with the numberof power plants under constructionrising from 33 in May 2008 to 44 today.Further evidence of growth comes from

INVESTMENT STRATEGYIN THE CURRENTENVIRONMENT


35

India which plans to increase thenumber of its nuclear plants by a factorof 4 times by 2020 and China by 10times within the same period.

There are a number of ways investorsmay benefit from this explosive growth.These could include investing in thecompanies that specialise in nuclearpower plant construction andoperation. Examples of such companiesinclude Westinghouse in the UnitedStates and both EGF and Areva inFrance. Of course it is for the investoror their advisors to undertake thenecessary investigation. Another areamight be the companies that mine andprocess the necessary fuel required bysuch nuclear plants. These would againinclude Areva in France, but alsocompanies like Cameco and otherspecialist miners, such as ExtractResources. A final potential marketwould be investing in organisations

involved in plant decommissioning andthe treatment and storage of the waste.Here apart from Areva, anothercompany worth considering might beBNFL Plc.

Fuel DevelopmentOne of the biggest problems withnuclear power plants is that the wastefuel and its reprocessed by-products(notably plutonium) can supply thematerial for nuclear weapons. It was byusing the waste from a Canadian-builtreactor that India in 1974 was able todetonate a nuclear bomb. There is aneed therefore for a new type of fuel tobe developed for the nuclear industrywhich does not produce any suchbyproducts.

Thorium Power, a company supportedby the US Department of Energy hasbeen working in Moscow since the mid1990s employing former Soviet

scientists and is researching and testingthe use of Thorium as a replacementfor uranium as well as developing theability to retro-fit existing power plantsto use the new fuel.

Thorium appears to offer theopportunity of a increase in yield and a70% drop in the overall production ofwaste and more importantly an 85% fallin the amount of plutonium (not a gramof which could be used for nefariouspurposes). Of course, it has to work….

With the largest known depositslocated in Australia, North America,Turkey and India, an investment in aThorium mining company could provespectacularly profitable should themetal deliver on some or all of itspromises.

ChinaThe International Monetary Fundforecast in March this year that itexpects GDP growth in China to be inexcess of 6% during 2009. Thiscontinues the strong growth achievedsince China began its move towards amarket-based economy in 1978. Overthis period of time its economy hasgrown by a factor of over 70 times withmost commentators concentrating theirreviews on the manufacturing costadvantages during this period and theresultant growth in exports to thedeveloped world. However, with thestrength of the Remnimbi over the pastfew years and the recent collapse inworld trade, this area has suffereddrastically.

In our view, China still appears to offerextraordinary investment opportunities– but investors should concentrate onthose entities that benefit solely fromgrowth in the domestic economy,rather than dependence oninternational trade. With a growingdomestic economy, the usual sectorsshould perform well (retail, consumerproducts and personal banking/ credit).An area that has strong growthfundamentals is the delivery of fuel fortransportation, including both petrolstations and LNG stations. There isalso a rapid growth expected in the useof alternative fuels for taxis, localauthority and government vehicles -China Natural Gas has exposure to thisarea. The recently announced hugeGovernment stimulus through capitaland infrastructure spend.

Investors could look further away fromthe norm to identify areas of futuregrow that appear relatively

INVESTMENT STRATEGY IN THE CURRENT ENVIRONMENT CONTINUED


36

Source: International Atomic Energy Agency

undiscovered. Demographics are a veryuseful investor tool and China is noexception in this. The IMF forecastthat China will experience the highestpercentage growth in the proportion ofthe population over 65 in the G20countries between now and 2040, by afactor of over 3.5 times. This fact,combined with the growth in thewealth of the country would seem toindicate a strong rise in therequirements for the provision ofhealthcare and related services andproducts. The fact that the ratio ofmale births to female births is currentlya very high 1.2 in China (versus 1.05for the world as a whole), would alsoindicate that investment in theprovision of healthcare services inChina could be refined further still.

UK Residential PropertyUK residential property has historicallybeen an outperforming asset class forinvestors (see the graphs below).

The current demand and supplyfundamentals of the UK housingmarket are in significantdisequilibrium, with a housingshortage that has been estimated toequate to between 7 and 10 years ofsupply (Source: Joseph Rowntree Foundation,Barker Report, NHBC). Projections of thenumber of households for England &Wales, and London and the South Eastin particular, indicate that demand forall types of residential property isexpected to increase rapidly over thenext 20 years. There is no sign that thehouse building industry will be able tokeep pace with these expectations evenwith the Government’s proposedhouse-building programme in theSouth East.

Certain commentators expect that thefall in UK house prices will emulate, oreven surpass, the decline in US houseprices. However, the characteristics ofboth the demand and supply profiles

for the two markets are very different.Various studies have calculated that theprice elasticity of supply for the USmarket is high (above 1) and isgenerally between 2 and 4 (meaningthat a 10% rise in house prices will leadto between a 20% and 40% increase inthe supply of houses) and could be ashigh as 20. In contrast, Kate Barker inher Interim Review, stated that the UKhousing market has “a low elasticity ofsupply in response to price changes”(i.e. a 10%increase in houseprices will lead toless than a 10%increase in thesupply ofhouses). Furtherher report statedthat not only do“UK householdshave a highincome elasticityof housingdemand, but alow priceelasticity ofdemand”. Thismeans (i) that ashouseholdincome rises, thedemand for housing rises faster; and (ii)that as house prices rise, demand forhousing will not decline in proportion,but much more slowly.

Currently, it is possible to acquireportfolios that yield up to 10% on costlocated in and around London thataddress the market segments with thegreatest projected excess of demandover supply. Investing instraightforward physical bricks andmortar provides its own comfort andrisk mitigation as compared toderivative and leveraged investmentproducts. With a high single figure netyield, investors can afford to be patientin awaiting future capital appreciation.

In conclusion, the recent marketturmoil will, if nothing else, forceinvestors to examine more closely themethods and rationale behind theirselection of investment assets and /orinvestment managers. History indicatesthat if an improvement is sought, thenone’s methods and constraints shouldchange – or at least be examinedafresh. It would be contrary to reasonto expect things to change whilst doingnothing differently.

INVESTMENT STRATEGY IN THE CURRENT ENVIRONMENT CONTINUED


37

With a high singlefigure net yield,investors canafford to bepatient in awaitingfuture capitalappreciation.

Well, they’re not our words. In fact they come from theSouth African Reserve Bank’s guidance on the InternalCapital Adequacy Assessment Process (ICAAP) which was akey document in a consulting assignment we recentlycompleted for a South African client. So we thought it wouldbe helpful if we spent some time pondering on this so-calledrevolution. Has one really taken place and, if it has, what arethe implications for internal auditors?

There is no question that a risk management revolution hasindeed happened and life in a bank, as we knew it, will neverbe the same again. The events that led up to the revolution

are spread over more than a decadeand are well documented. Theyinclude the deregulation andglobalisation of financial markets,business consolidations throughmergers and acquisitions and greaterconcentrations of processing power infewer locations enabled by the rapidpace of technological innovation.Most important, perhaps, is theemergence of risk intermediation andthe proliferation of securitisations andderivative transactions and an everincreasing complexity of dealstructures.

The truth is that this advancingsophistication of financial productsand the markets where they are tradedhave combined with technologicalinnovation to produce a new reality.Banks must now come to terms withthe fact that when trades andtransactions enter their operating

environments they trigger risk exposures that can go wellbeyond nominal transaction values.

The current financial crisis can be linked to accumulating riskexposures which, in a number of well publicized cases,escalated to $ billions without always finding expression inthe affected banks’ financial accounting and risk reportingsystems. The Société Générale fraud and sub-prime failuresare such examples. What is also evident is that suchunidentified and unmeasured accumulations of risk were notattributable to any particular category of risk but a ratherpotent cocktail of all of them… credit, market, liquidity andoperational.

These events served to heighten the awareness of banks andregulators to the need for the ongoing identification,measurement and management risks across the enterprise.The global regulatory response was Basel II complemented by

a requirement from most national regulators that banksconfirm, in their Internal Capital Adequacy AssessmentProcess (ICAAP), that all risks have been identified andmeasured, are subject to appropriate management and arecovered by sufficient capital reserves. There is also a directimpact on internal auditors as every regulatory authorityaround the world that we are aware of requires that theICAAP be subject to regular internal audit.

But if the evidence suggests that conventional financial andrisk management systems are simply not capturing andreporting all of a bank’s exposures to risk, what chance doesinternal audit stand of identifying unreported and / orimproperly measured risks during the course of their audits?The answer is quite a good one provided the audit plan issuitably risk-based and the audit team has the necessary skillsand preparation. This may be easier said than done.

There are two ways Risk Reward can help:

TRAININGWe have first class internal audit courses that have beendeveloped by leading experts covering risk management,capital management and the ICAAP and our trainers are thebest in the business. In the post ‘Risk ManagementRevolution’ era these are the skills that all your auditors mustpossess.

CO-SOURCINGA solution that is becoming increasingly popular with ourclients. Risk Reward will provide seasoned audit professionalswho are experts in risk management and specialize in thetechnical areas where risk exposures are likely to be prevalent,for example, Treasury. Co-sourcing ensures you have thenecessary skills available in your audit team withoutcompromising any of your managerial integrity or auditingmethods. Our experts will readily adapt to your auditingmethods and approaches and all working papers prepared bythem are your property and form an integral part of youraudit’s working papers. They can contribute to any aspect ofthe audit at your entire discretion… audit planning,programme writing, field work or report writing. As we arenot a firm of external auditors there are no conflicts ofinterest. Indeed, on the occasions that there has beeninteraction with regulators they have positively endorsed co-sourcing.

CO-SOURCING OR THENEW WAY TO ENSUREAUDIT EXCELLENCEHAVE WE REALLY BEEN THROUGH A RISK MANAGEMENTREVOLUTION?


38

‘There is noquestion that arisk managementrevolution hasindeed happenedand life in a bank,as we know itwill never be thesame again.’

What is Stress Testing?

The Bank for International Settlements(BIS) published a paper under theChairmanship of Mr Klaas Knotentitled “Principles for sound stresstesting practices and supervision” inMay 2009. It stated that stress testingplays an important role in:

■ providing forward-lookingassessments of risk;

■ overcoming limitations of modelsand historical data;

■ supporting internal and externalcommunication;

■ feeding into capital and liquidityplanning procedures;

■ informing the setting of a bank’s risktolerance ; and

■ facilitating the development of riskmitigation or contingency plansacross a range of stressed conditions

We define sensitivity analysis as theunitary movement of key variables andthe stress test as the impact of takingsuch movements to a plausible extent.Basically you look at the relationshipsthat underpin the analyses and thenlook to see at what point therelationships fail to hold together. Thepoint at which an accepted (orexpected) relationship breaks down canbe defined as the Stress Event. Withprevious Basel papers the soundnessstandard had been set at 99.9%, so itwould appear appropriate to use thesame confidence level for stress testingas is used for capital calculation.

Before looking at the principlesthemselves, one should ask a number ofquestions: Can stress testing reallyachieve what is suggested in the paper?Can stress testing achieve what isclaimed? Is it forward looking? Wellstress testing certainly looks toascertain the financial impact of whatmight happen in a relatively unlikelyevent - but even if that event is foundto be manageable, the evaluation ishardly likely to be accurate. Can it getover the model problems and thelimitations of historical data? Since thestress testing uses these modelsextensively it surely cannot achievethat – and it is calibrated usinghistoric data.

Communication is a real problem.Providing the populace with data to

deal with events that are unlikely tooccur is likely to cause unnecessaryconcern. Even internally informationneeds to be provided with care – butexternally?? Be scared – be veryscared.

Risk tolerance is set by the Board anddrives other behaviours as set outabove. It is a view about the goals andmissions of the bank and the appetiteof management to the level of risk thatthey are willing to take. The stresstesting will tell the bank the events thatare unacceptable so that they canchange the approach and avoid the lossoccurring. This idea that stress testingneeds to result in action is absolutelycrucial and needs to be consideredcarefully by management. So given thatthe objectives for stress testing in theintroduction are open to question –how about the principles themselves?

Principle 1Stress testing should form an integralpart of the overall governance andrisk management culture ofthe bank. Stress testingshould be actionable,with the results fromstress testinganalyses impactingdecision making atthe appropriatemanagement level,including strategicbusiness decisions ofthe board andsenior management.Board and seniormanagementinvolvement inthe stress testingprogramme isessential for itseffectiveoperation.

AnalysisThis focus on corporate governance iswelcomed and important, operating asit does throughout all subsidiaries ofthe bank. If there is no action resultingfrom the calculations conducted, theentire process becomes meaningless –turning into a pointless mathematicalexercise. The strategic options maywell include ceasing some form of salesactivity to alter the risk profile, forexample.

Principle 2A bank should operate a stresstesting programme that promotesrisk identification and control;provides a complimentaryperspective to other riskmanagement tools; improves capitaland liquidity management andenhances internal and externalcommunication

Analysis This is the principle that is a littleconfusing. Banks should maintain risk

registers as a fundamental part ofrisk management, with each

risk clearly identified anddesignated. Capital

management is based onthe expected loss andincome data, so stresstesting will not

directly impactthis exercise.

Liquidityreserve

STRESS TESTING PRACTICESAND SUPERVISION


39

lines and strategies may be based on likely or plausible stresstests, but these also are at an extreme – not in the day-to-day.Communication can be dangerous - as has been seen in partin this crisis through the inappropriate explanations providedby journalists who should know better.

The paper does include the requirement that stress testing isfundamental within the internal capital adequacy assessmentmodel or ICAAP –but this is about how the regulators assessthe capital within a firm, and is in itself perhaps questionable.That the ICAAP must address such matters (together withrisk appetite) will encourage banks to look towards suchplausible events and is clearly welcomed.

Principle 3Stress testing programmes should take account of viewsacross the organisation and should cover a range ofperspectives and techniques.

AnalysisThis is where the BIS link stress testing with scenario analysis,without really adding anything new.

Principle 4A bank should have written policies and proceduresgoverning the stress testing programme. The operation ofthe programme should be appropriately documented.

AnalysisThey state that the following should be documented:1. the type of stress testing and the main purpose of each

component of the programme;2. the frequency of stress testing exercises;3. the methodological details; and4. the range of remedial actions envisaged.

How bold of them! These requirements really onlyrepresent common sense – which perhaps is not verycommon and can, of course, keep the internal and externalauditors busy! Interestingly we are now through fourprinciples without actually giving any real guidance to anyoneas to what should be done in practice.

Principle 5A bank should have a suitably robust infrastructure inplace, which is sufficiently flexible to accommodatedifferent and possibly changing stress tests at anappropriate level of granularity

AnalysisIs this really guidance? We recommend that the suite of stresstests should be conducted monthly where possible andreviewed quarterly to ensure that they meet the demands ofthe market and the business. This, of course, is real guidance,so clearly would not be in the principles.

Principle 6A bank should regularly maintain and update its stresstesting framework. The effectiveness of the stress testingprogramme, as well as the robustness of major individualcomponents, should be assessed regularly andindependently.

AnalysisThey state that the independent control functions such as riskmanagement and internal audit should also play a key role in

the process, although what this role should be is notspecified. Of course internal audit will conduct such work asthey consider appropriate, so that is clear. Risk managementin many cases are conducting the stress tests and if thewording here is suggesting that this should not be the case,then it would be a major change for many firms – whichperhaps in time will be appropriate.

Principle 7Stress tests should cover a range of risks and businessareas, including at the firm-wide level. A bank should beable to integrate effectively, in a meaningful fashion,across the range of its stress testing activities to deliver acomplete picture of firm-wide risk.

AnalysisThe integrated stress testing requirement has been statedbefore. However firms, and to some extent regulators, havestill been looking in silos. The stress tests used for marketrisk, for example, were rarely considered in credit risk. This isboth illogical and unhelpful, so these requirements may helpto redress this issue.

Principle 8Stress testing programmes should cover a range ofscenarios, including forward-looking scenarios, and aimto take into account system-wide interactions andfeedback effects.

AnalysisI think this really repeats previous principles.

Principle 9Stress tests should feature a range of severities, includingevents capable of generating the most damage whetherthrough size of loss or through loss of reputation. A stresstesting programme should also determine what scenarioscould challenge the viability of the bank (reverse stresstests) and thereby uncover hidden risks and interactionsamong risks.

AnalysisWhat is interesting here is the term “most damage”. Thispoor wording means that the worst case scenario should beconsidered. I suppose that would be 385,000,000% inflation,for example… but if that is not plausible what is the point ofworking it out? I suppose the sun could go out and everyonecould die – any point in working out the impact? What wouldthe action be? Move to Mars??

Earlier I suggested we aim for the 99.9% soundness standardfor consistency and I would hope that is what the target inpractice will be. Of course we do not expect to hit the targetaccurately – it is stress testing after all and at best an estimate.

The Other principles are:

Principle 10As part of the overall stress testing programme, a bankshould aim to take account of simultaneous pressures infunding and asset markets, and the impact of a reductionin market liquidity on exposure valuation.

Principle 11The effectiveness of risk mitigation techniques should besystematically challenged.

STRESS TESTING PRACTICES AND SUPERVISION CONTINUED


40

Principle 12The stress testing programmes should explicitly covercomplex and bespoke products such as securitisedexposures. Stress tests for securitised assets shouldconsider the underlying assets, their exposures tosystematic market factors, relevant contractualarrangements and embedded triggers, and the impact ofleverage, particularly as it relates to the subordinationlevel in the issue structure.

Principle 13The stress testing programme should cover pipeline andwarehousing risks. A bank should include such exposuresin its stress tests regardless of their probability of beingsecuritised.

Principle 14A bank should enhance its stress testing methodologies tocapture the effect of reputational risk. The bank shouldintegrate risks arising from off-balance sheet vehicles andother related entities in its stress testing programme.

Principle 15A bank should enhance its stress testing approaches for

highly leveraged counterparties in considering itsvulnerability to specific risk categories or marketmovements and in assessing potential wrong-way riskrelated to risk mitigating techniques.

AnalysisPrinciples 16 to 21 provide the rules for the supervisors andreally echo the principles for the banks. As you can see whatthey have actually done is provide some high level principles,then allowed some people to put in specific areas thatconcern them now. These are not forward looking concernsfor what might happen in the future – for example a massiveincrease in interest rate volatility or a US default – rather theyare things that have happened and would actually appear in ahistoric data set. So many words and so little content, butremember it will be reviewed “regularly andcomprehensively”, so no doubt we will all be tying ourselvesup in ‘Knots’ to make sure we comply. In doing so please donot lose sight of the objectives of stress testing – to enableyou to see what might happen and then GET OUT OFTHE WAY. This is not about counting the dead; it is aboutprolonging the living.


41

There is much to both admire andpraise about Islamic Finance. Its statedethos and principles are probably asclose to a model for truly ethical andmoral banking that has yet beendeveloped and actually implemented ona large scale.

Based on the Quran, Islamic Financeoffers its clients Shari’ah compliantbanking but the real meaning and to befair, the true benefits of this, are oftenlost on Western observers, some ofwhom have tended to dismiss thesector as yet another example offundamentalist religious doctrineapplied to real life. But this cynical viewis not only undeserved it is also mostlyinaccurate. In reality, even a cursorystudy of Islamic Finance and its guidingprinciples will confirm it is indeedprobably the most successful model forethical banking to date. But it is notwithout its weaknesses, not least ofwhich is whether any institution can

actually achieve the blueprint and liveup to its full potential. The answer isalmost certainly “no” but does thisdetract from its merits?

The whole concept of Shari’ahcompliant banking is by Western termsstill very much in its infancy. Someconventional banks have been tradingfor more than 400 years, most for atleast 50 and it is often a surprise tomany observers that modern IslamicFinance actually started in its presentformat as recently as 1985. Of coursetrading and commerce in the Islamicworld is actually thousands of years oldand pre-dates not only banking butIslam itself. The remarkable legacy ofthis ancient history is that the basictrading contracts have been refinedover millennia and still survive, stillwork (in the main) and still underpinIslamic Finance.

The guiding principle of Islamic

Finance is to provide banking andfinancial services which are compliantwith Shari’ah. Shari’ah is the DivineLaw as revealed in the Quran (Book ofAllah SWT) and Sunnah (words oracts) of His Prophet Muhammad(PBUH).

The primary authority for Shari’ah isthe Quran which means “the text ofGod” and is actually a blueprint forrunning a society with detailed rulescovering every aspect of a Muslim’s lifeincluding religious, family, communityand of course trading obligations. Itstresses fairness, honesty, integrity andmorality to all, even towards non-believers, which comes as a surprise tosome people.

Next is the Sunnah which means ‘wellknown path’. It covers the words, actsand tacit approvals of the Prophet(PBUH) as recorded at the time andsubsequently and includes the Sayings

ISLAMIC FINANCE AN INTRODUCTIONTHIS IS THE FIRST OF TWO ARTICLES INTRODUCING ISLAMIC BANKINGAND FINANCE CONCEPTS WRITTEN BY MARK ANDREWS, HEAD OFISLAMIC BANKING AND FINANCE, RISK REWARD LTD.PART 2 WILL APPEAR IN THE NEXT RISK UPDATE Q3 2009.

(Hadith) which He used to lay downthe law and give moral guidance.

Next comes Ijma or“consensus/agreement” under whichsuitably qualified Islamic Scholars orJurists are asked to rule on points ofShari’ah law where the answer is notimmediately available from the twosenior sources. Then follows Qiyas or“analogy”, which extends the law byapplying common underlyingattributes. Finally there is Ijtihad or“interpretation “, where IslamicScholars are asked to rule on anapparently unique problem.

This structure seems to becomprehensive enough until you arereminded that the primary sources, theQuran and the Sunnah, are actually1,400 years old and chronicle themoral, commercial and religiouschallenges of that time. Even thoughthe Prophet (PBUH) was clearly apragmatist and may well haveaccommodated some of the modernstructural differences, it is obviously amatter of faith that the historical textsare doctrine and must be appliedliterally and strictly.

Having to apply ancient standards tomodern banking is and has been a realchallenge. Critics say it is disingenuousinvolving replication and retrospective“shoe horning” to make it fit, but thisdismissive swipe cheapensunreasonably the value of what hasbeen achieved in a very short time. Ifyou study the subject in detail it is hardnot to congratulate most scholars forreaching remarkably successfulcompromises even where the challengeseemed incapable of being resolved.

Underpinning Islamic Finance areseveral basic rules which cannot all belisted in detail in this article but themain ones are:

■ No uncertainty■ Trade must be in real goods and

assets■ Sellers must be honest, totally frank

and actually own what they sell■ There can be no speculation or

gambling ■ No trade in activities or products

considered Haram or un-Islamic

These prohibited activities aregenerally well known and include notrade in pork, alcohol, armaments,pornography, etc.

The most significant basic rule and the

onethatperhapsmost definesthe ethos of IslamicFinance, is that all commerce mustinvolve the real sharing of both profitsand losses so that all parties, includingthe bank, have a real and tangible stakein the outcome of the transaction beingundertaken. Consequently, and unlike aconventional bank which does, anIslamic Bank does not have a debtor orcreditor relationship with its depositorsand customers.

With one exception (Amanah or Trustaccounts which are safe custodydeposits and are not usually significantin numbers or amount) “depositors” areactually investors, all of whom agree toinvest alongside or via the Islamic bankand whose return is based on a share ofthe banks actual profit and losses.Investors place money in the Islamicbank as trading partners and are given aprofit (and loss!) sharing share basedon the term, purpose, maturity, etc ofthe investment.

The actual investor accounts are basedon the ancient contracts of Amanah,Wikala, Wadia, Mudaraba andMusharaka but are generally alsoreported as current accounts,investment accounts and specialinvestment accounts by many IslamicBanks.

The key difference between Islamic“investors” and the “depositors” in aconventional bank is that Islamicinvestors agree to share profits andlosses whereas conventional depositorsdo not, especially the loss part! Intheory, therefore, a loss making IslamicBank could and should pass on theselosses to its investors who would seetheir investments reduced as aconsequence.

So far, this has not been put to the testin a major way and it is debatablewhether an Islamic Bank could actuallypass on losses on a large scale, giventhat in reality most investors regardtheir stakes as a one way bet. Would ittrigger a Northern Rock exodus?Possibly.

There are many myths about IslamicFinance principally that it is banking forMuslims only. This is not true at all.Anyone can open an investmentaccount and apply for the full range ofservices on offer. Non-Muslims arewelcomed.

Thebiggest challengefacing the sector isliquidity but not in quitethe same sense that we use whenlooking at conventional banks. In aconventional bank liquidity is neededto repay depositors and liquidity“difficulties” usually means the bankcannot meet their withdrawal requests.It is fear that drives this process andusually triggers panic, which in turnstarts a wholesale stampede asdepositors jostle to get their money outfirst. Restoring confidence, veryquickly, is the only solution, somethingthe authorities failed to do withNorthern Rock.

Faced with bank collapses in the West,all Islamic jurisdictions made it clear inunequivocal terms that they stood fullybehind the Islamic banks in theirterritories. As these territories includedsome of the richest countries in theworld, most Islamic investors are nowsatisfied that the risk of losing theirmoney is minimal. Anecdotal evidencefrom various institutions suggestsinvestors having seen the worst are nowrelaxed and no major withdrawals havebeen reported.

The liquidity challenge in Islamic banksis actually a treasury and profitabilityproblem. There is no effective Islamicinter-bank market and banks cannotlend to or borrow from each other inconventional terms. As a result a bankthat finds itself with too manyinvestments or is short of cash, haslimited options. The issues posed bythis are beyond the scope of this articlebut typically surplus funds have to beheld in low or nil yielding cash formand shortfalls are met by seekingdiscreet deposits from sovereigndepartments on a “lender of last resort”basis. This “super tanker” approach toliquidity management will be a realconstraint on future growth.

Islamic Finance: Part 2

In the next quarterly Risk Update weconsider Riba or the banning of interestand the asset side of an Islamic Bank,including Musharaka which should bethe star of Islamic banking but sadly isnot.

ISLAMIC FINANCE CONTINUED


42

Peter J Hughes, Head of Risk & Internal Audit at RiskReward Ltd, (former Head of Internal Audit,ChaseManhattanBanco, Brazil), is a risk-based bankinternal auditor co-sourcing and training in emergingmarkets. Two recent assignments, one for a Gulf bank andone southern Africa bank led him to suggest here it isworth investing in a high quality, modern risk-based auditfunction as one major positive step towards meeting Baselrequirements and preventing the next financial crisis.

In October 2006 the Basel Committee on BankingSupervision issued its Core Principles Methodology whichsets the standards for the prudential regulation andsupervision of banks. Among its 25 principles is Principle 17that addresses internal audit and control. Specifically, withrespect to Internal Audit, supervisors will need to concludewhether a regulated bank:

■ “has sufficient resources and staff that are suitably trainedand have relevant experience to understand and evaluatethe business they are auditing;

■ has appropriate independence, including reporting lines tothe Board and status within the bank to ensure that seniormanagement reacts to and acts upon its recommendations;

■ has full access to and communication with any member ofstaff as well as full access to records, files or data of thebank and its affiliates, whenever relevant to theperformance of its duties;

■ employs a methodology that identifies the material risksrun by the bank;

■ prepares an audit plan based on its own risk assessmentand allocates its resources accordingly; and

■ has the authority to assess any outsourced functions.”

Apart from setting high expectations, Principle 17 expectsInternal Audit departments to have a methodology thatidentifies material risks and an audit plan based on its own riskassessment. In other words, there is an expectation that bankswill have adopted risk-based audit approaches.

So what is risk-based audit? In his book Phil Griffiths1

describes risk-based auditing as, ‘a process, an approach, amethodology and an attitude of mind rolled into one’. Thismay seem a little vague. But there’s a good reason for thisvagueness because there’s no standard risk-based ‘one-size-fits-all’ audit template. Quite simply, it’s about being totallyprofessional.

The best analogy for risk-based audit is to be found in adoctor’s surgery. The good, professional doctor is highlytrained to recognise and interpret the symptoms of ill health,makes enquiries to understand what the patient is suffering orpotentially could suffer, conducts an examination to identifyand assess the causes of the suffering, decides on a course oftreatment to remediate the causes and monitors the patient toensure that the course of treatment is being adhered to andhaving the desired effect.

This doctor analogy applied to banking is what risk-basedauditing is. Gone are the standard audit checklists and audit

programmes that are applied systematically and repetitivelyand, sometimes mindlessly. Gone are the audit reports thatonly discuss what the auditor did and found with theaccompanying exception statistics. Gone is the auditor whosits in judgement of management and staff to declare them‘satisfactory’ or ‘unsatisfactory’ or even ‘marginallysatisfactory’.

Instead we have a new breed of auditor who has in-depthunderstanding of the business, knows how to identify andassess the risks inherent in the business, is able to applyexpertise and creativity to suggest and agree withmanagement how identified risks can be most effectivelymitigated and writes audit reports that explain the risks withappropriate quantification, the actions agreed to mitigate therisks to acceptable levels and details of the cost benefit ofsuch actions and their risk reduction impact.

Many banks now perceive a need to modernise their internalaudit function. Indeed, Risk Reward is advising a number ofclients on audit modernisation programmes and providingimmediate solutions through co-sourcing2 and training.

It’s a moot point whether higher standards of auditing wouldhave prevented the current financial crisis and theconcomitant failures, bailouts and nationalisations thataffected banks of all sizes. But one thing is for certain... it’sprobably worth investing in a high quality, modern auditfunction as one major positive step towards preventing thenext financial crisis.

1 Risk Based Auditing by Phil Griffiths, published by Gower Publishing Limited2 Refer to the article in the Risk Update Q1 2009 ‘Co-Sourcing or the New Way to

Ensure Audit Excellence’

BASEL SETS THE STANDARD...ISYOUR BANK INTERNAL AUDITFUNCTION UP TO IT?


43

IntroductionThe US hedge fund firm, MadoffSecurities LLC, was recently exposedas a giant pyramid scheme and lossesderived from its inevitable collapse arenow estimated at US$50 billion. BernieMadoff – the owner of the firm – hadprovided investors with modest, steadyreturns, claiming to be generating theseby trading in Standard & Poor’s 500Index options. All positions wereclosed prior to mandatory reportingdates so investors were denied accessto the hedge fund holdings. Madoffwas a former chairman of NASDAQStock Market Inc., well-known, popularand apparently above suspicion:individuals, charities and numerous‘funds of funds’ had invested in MadoffSecurities hedge funds, amongst themHSBC Holdings PLC and BancoSantander SA. The steady positivereturns Madoff offered to his clientele– even in turbulent times – perpetuatedthe illusion of responsible investing.

The severity and reach of these losseshave been disastrous. That the fraudescaped regulatory scrutiny – as well as

suspicion, given the level of investornous – is difficult to comprehend. TheUS agency responsible for fundoversight (the Securities and ExchangeCommission) has claimed that, withoutsignificantly more information than the

reported monthly fund returns, it couldnot have detected foul play.

The Bias ratio, introduced in 2008, is anew metric devised to highlightpossible fund return manipulation. Assuch, the ratio may be used as anindicator (but not ultimate proof) offraudulent activity. Despite its novelty,the Bias ratio would have identifiedsuspicious activity early in the historyof the deception (i.e. using relativelyfew monthly return data): results showthat deliberate attempts by Madoff toskew smooth monthly returns wouldhave been exposed after only eightmonths. The need for widedissemination of just such earlyindicators is important, particularlygiven the fragile nature of the currentmarket which is prone to overreactionto bad news.

The remainder of this review article isstructured as follows. Section 2presents a brief literature overview ofthe subject of the fraudulentmanipulation of returns and otherfinancial statistics. Section 3 outlines

the mathematicsunderlying theBias ratio andSection 4 thenexplores someinterestingfeatures of themeasure. A basecase (a normaldistribution ofreturns) isdetermined andother potentialreturndistributionsassessed relativeto this base case.

The Madoff fund returns are thenscrutinised using the Bias ratio and, forcompleteness, three different sets ofhedge fund returns (which each employa different investment strategy) areexamined using the new metric.

Section 5 concludes the article.

What the Literature Says Several studies have reported strongevidence of a positive relation betweenfund performance and the subsequentflow of investor capital. Berk and Green(2004) interpreted this relationship asthe entirely rational response toupdated beliefs about fund managers’investment skills. Even after allowingfor cumulative returns, investorsexhibit an incremental sensitivity to thenumber of prior monthly losses – inother words, zero was found to be apowerful ‘quantitative anchor’. Inaddition, in order to consistentlyachieve positive returns (no matterwhat the economic milieu), manyinstitutional investors pursue ‘absolutereturn’ strategies (Waring and Siegel,2006). Investors are also prone toexaggeration – particularly in thecurrent fragile economic environment –and tend to overreact to bad news (forexample, when a negative monthlyreturn is reported, regardless of howsmall the negative return) lest worsenews awaits.

The prevalence of misreporting in thehedge fund industry was investigatedby Bollen and Pool (2008) whoexamined discontinuities in pooledmonthly returns.1 A sharp discontinuitywas indeed detected at zero: thenumber of small gains was significantlygreater than expected while thenumber of small losses was substantiallylower. An interpretation of the anomalywas that hedge fund managers distortmonthly returns to avoid reportinglosses. If this construal were correct,subsequent fund performance shouldweaken since overstatement musteventually reverse (though this may notnecessarily occur in the monthimmediately subsequent to the

THE BIAS RATIO – CANFRAUD BE MODELLED?Gary van Vuuren PhD, a risk and financial modelling expert asks the question can fraud risk be modelled and thereforepredicted. The US$50bn losses expected from the US firm, Madoff Securities (recently exposed as a giant pyramidscheme), are severe and extensive. Astonishingly, the fraud escaped regulatory scrutiny for years. The Securities andExchange Commission claims that only monthly returns were provided and these did not warrant suspicion. Had theBias ratio – a metric which augurs potential fraudulent activity – been applied, potential deception would have beensignalled after only a few months of monitoring returns. Gary offers a description of the ratio and suggests a practicalimplementation scheme and then further illustrates this on a South African hedge fund returns.


44

1 These returns were those reported to the Center for International

Securities and Derivatives Markets (CISDM) database from 1994 to

2005. The CISDM database includes live and defunct hedge funds,

funds of funds, CTAs, commodity pool operators, and indices.

overstatement month). Results fromseveral tests concluded that, indeed,the discontinuity was due totemporarily overstated returns Bollenand Pool (2008). The discontinuity wasalso found to be prevalent in both liveand defunct funds, so it was not simplya reflection of survivorship or backfillbias.

Approximately 10% of fund returnsstudied were distorted, indicating thatoverstating returns was a widespreadoccurrence. Though these small returndistortions do not place investors atrisk directly, they could indicate a moreserious violation of managerial fiduciaryduty. Fund net asset values were alsooverstated when returns wereoverstated resulting in new investorsoverpaying for entry to the fund(Getmansky, Lo and Makarov, 2004). Ifreporting of fund losses is avoided,investors may underestimate hedgefund risks and overestimate managerialperformance. As a direct result,investors may allocate more capital tohedge funds than is warranted.

Getmansky, Lo and Makarov (2004)also report that the purposefulsmoothing of hedge fund returnsbiased fund volatility downwards andthe Sharpe ratio upwards.

Fund returns were also found to bepositively serially correlated. Serialcorrelation does not necessarilyindicate misreporting: positive serialcorrelation is sometimes recordedwhen marking to model those fundswhich are invested in illiquid securitieseven though there is no intention todeceive. Bollen and Pool (2008)speculated that a fund manager wouldbe more likely to smooth losses thangains, resulting in greater serialcorrelation when funds perform poorly.Cross-sectional analysis indicates thatthe propensity for funds to featureconditional serial correlation ispositively related to proxies for the riskof capital flight.

Carhart et al. (2002) examined thedaily returns of equity mutual fundsaround quarter (and year)ends andfound that funds with the highest year-to-date returns tended to feature largerreturns on the last day of a quarter (or ayear). These returns were largelyreversed the following day. Carhart etal. found that some mutual fundmanagers temporarily inflated fundasset values by adding illiquid stocks totheir positions on the final day of aquarter (or a year). Buying pressure

then increased trade prices and theentire position was re-valued upwards.Next-day reversals providedconvincing evidence that year-endperformance was distorted, since theimpact of the trading activity on thelast day of the year is only temporary.

Agarwal, Daniel and Naik (2007a)found that average hedge fund returnswere higher in December than all othermonths. The incentive for fundmanagers to report higher end-of-yearreturns was measured and theDecember pattern was found to bemore pronounced for managers withhigher incentives.

Several studies have also documentedevidence of discontinuities in corporate

earnings or changes in corporateearnings around zero, including Hayn(1995), Burgstahler and Dichev (1997)and Degeorge, Patel and Zeckhauser(1999). Dechow, Richardson and Tuna(2003) as well as Burgstahler andDichev (1997) found a discontinuity inthe distribution of corporate earningsdeflated by market capitalisation.

Large Sharpe ratios have been used toindicate possible fraud (KPMG,2009:6), Asset purchase prices, returns,periodic growth rates, dividends andother relevant statistics have beenemployed to accurately assess assetreturn values, but for illiquid assetsthese may not be readily available norreliable. The Bias ratio, introduced byAbdulali (2006), may be used toovercome limitations inherent in otherstatistics and may also be applied tostatistics suspected of manipulation.Some evidence of positive correlationbetween Sharpe and Bias ratios exists:

principal components and neuralnetworks have been used in evaluatingthis evidence, but these are complex toimplement and the output is no lessambiguous than that derived frommuch simpler techniques (Derrig,2005).

The Madoff fund has now beenexposed as a Ponzi scheme.2 Theseoffer abnormally high short-termreturns to entice new investors. Theperpetuation of high returns requiresan ever-increasing flow of investorfunds in order to maintain the scheme.Ponzi schemes have been responsiblefor US$ billions (Algo, 2009), butMadoff’s deception dwarfs theremainder, as shown in Table 1.

Technical Details The Bias ratio operates on return datawith mean μ and standard deviation σ.A closed interval [0.0, + 1.0σ] and ahalf-open interval [–1.0σ, 0.0) is thendefined. The fund return in month i isr i where 1 ≤ i ≤ n and n is the totalnumber of returns in the data series.The Bias ratio (BR) is then defined as:

(1)

The numerator summation is over theclosed interval [0.0, +1.0σ] while thedenominator summation is over theopen half interval [–1.0σ, 0.0). The


45

Table 1: Large Ponzi schemes sorted in order of decreasing loss amounts.

Organization Loss Amount Settlement DateBernard Madoff Investment Services LLC 50,000,000,000 11-Dec-08Princeton Financial Group 950,000,000 14-Sep-99Mutual Benefits Corp. 837,000,000 31-Dec-04Bennett Funding Group Inc. 750,000,000 01-Jan-97RBG Resources 597,393,000 01-Jun-02Towers Financial Corporation 500,000,000 31-Dec-93InverWorld 325,000,000 01-Jan-99Evergreen Security, Ltd. 214,000,000 31-Dec-01Mustang Development 139,000,000 31-Mar-95Gestion Privee Japon 102,000,000 31-Jul-05

Source: Algo FIRST Newsletter.

2 Fraudulent investment operation that pay returns to investors from

their own invested funds or paid by subsequent investors rather than

from profit.

small positive constant,k , is included inthe formulation to prevent division byzero in cases where there are no returnsreported in the interval [–1.0σ, 0.0). Incontinuous terms, Equation 1 may bestated as follows:

(2)

The Bias ratio also has the followingproperties:1. 0 ≤BR ≤ n ,2. if r i ≤ 0 , ∀i then BR = 0 and3. if r i > 0 , r i > +1 σ, ∀r i then BR = 0.This formulation is easily implementedin spreadsheet software: only returndata are required as input.

Data and Results To understand the operation of theratio, first consider normally

distributed data with μ=0% and σ=1%as shown in Figure 1. A histogram ofthe data is shown as well as the normaldistribution curve on the same x-axis.

The area (using the histogram) over theintervals [0.0,+1.0σ] and [–1.0σ, 0.0)are identical for a normal distribution,hence using Equation 1, BR = 1.0.Return data manipulation should ideallybe signalled by several indicators,rather than total reliance upon only asingle – potentially fallible – one. Thereare many ways in which return datamay be manipulated, these will bedistributionally manifest in prominentways, i.e. through the mean and theoverall shape of the curve, e.g. theskewness and kurtosis. The statisticalcoefficients of skewness and excesskurtosis (i.e. >3) are thus included inFigure 1 for comparison. For a normaldistribution, both of these are 0: thevalues indicated in Figure 1 above aremeasured values.

Assume first that theshape of thedistribution (in thisexample, normal) ismaintained, but theaverage return hasbeen altered. There isclearly no incentive toadjust returns suchthat the new averagereturn is lower thanthe true mean, hence,any modification islikely to shift themean in such a way asto only increase it.The situation isshown in Figure 2.The data are normallydistributed, but nowwith μ=+1% andσ=1%. Thehistogram and normaldistribution curve areagain shown on thesame x-axis.

The areas measuredover the requisiteintervals are nolonger identical. Inthe exampleillustrated in Figure 2,Area:[–1.0σ, 0.0) <Area:[0.0, +1.0σ) andEquation 1 givesBR = 2.5. Note thatFigure 2 is forillustrative purposesonly: there are aninfinite number of

Bias ratios (all > 0) that could arisefrom an infinite number of ‘mean returnadjustments’. It is important to note,however, that a Bias ratio > 1.0 shouldnot automatically trigger suspicion ofwrongdoing. Skilled fund managers caneasily (and often do) obtain Bias ratios> 1.0 with no deception involved. It isthe maintenance of these high Biasratios for long periods of time as well asthe magnitude of the excess above 1.0that should provoke suspicion.

Assume now that the shape of thedistribution is lognormal. Again, thereis no incentive to adjust returns suchthat these returns are negativelyskewed (i.e. a long tail to the left of0%): any fraudulent modifications arelikely to adjust returns such that thealtered values are positively skewed, i.e.to the right of 0%. The situation isshown in Figure 3. Since the Bias ratioformulation assumes a normaldistribution3 (for the calculation of μand σ), the ‘fit’ in Figure 3 is thereforenot accurate.

In the particular example shown inFigure 3, Area:[–1.0σ, 0.0) < Area:[0.0,+1.0σ) and Equation 1 gives BR =3.67. In this case, in addition to thesuspiciously high Bias ratio, the highpositive skewness of +1.93 (indicatinghighly skewed returns) and the largeexcess kurtosis of 8.12 both also warnof potential misrepresentation.

Turning to a practical example – ahistogram of the monthly returns fromMadoff’s Fairfield Sentry hedge fundrecorded since 1990 are shown inFigure 4 facing. Superimposed is thebest fit normal distribution.

In this case, Area:[–1.0σ, 0.0) <<Area:[0.0, +1.0σ) and Equation 1 givesBR = 13.5. This value is particularlyhigh although even a cursory glance atthe histogram of returns showssuspiciously few returns below 0%measured over some 19 years. Therelatively high positive skewness andexcess kurtosis combined with the Biasratio, should have provoked scepticism.The important conclusion is that theseindicators are all measured using onlymonthly returns.

For completeness, the return series ofthree different strategies of SouthAfrican hedge funds were investigatedusing this analysis. There are differentquantities of returns: some were

BASEL SETS THE STANDARD ... IS YOUR BANK INTERNAL AUDIT FUNCTION UP TO IT? CONTINUED


Figure 1: Histogram of normally distributed return data with μ=0% andσ=1% and normal distribution superimposed over the same data bins.

Figure 2: Histogram of normally distributed return data with μ=+1%and σ=1% and normal distribution superimposed over the same databins.

Figure 3: Histogram of lognormally distributed data. The normaldistribution is superimposed over the same data bins.

46

2 The area used in the Bias ratio formulation is, however, empirically

derived.

measured over the period January 2000to December 2006, others later, but allspanned at least four years ending inDecember 2006.

Although the skewness coefficient ishighest in (b) – the market neutral fund– this value is not disproportionatelyhigh. Analysis indicates, however, thatall three strategies report high Biasratios and kurtosis coefficients. Inparticular, the Bias ratios of fundsemploying market neutral and fixedincome strategies might hint at possiblereturn manipulation. These results arenot presented to raise the alarm onSouth African hedge funds, but ratherto illustrate real-life examples ofmeasured Bias ratios and point out theconclusions that may be drawn fromhigh values thereof.

ConclusionsThe early detection of fraud – or at thevery least – the early signalling ofpotential fraud is of paramountimportance at all times, but particularlyin the current economic milieu offalling asset prices, failed banks,reduced lending and broad marketuncertainty. The Madoff Securitiesdeception cost investors many US$billions and, at the time of writing(February 2009), these have not yetnecessarily all been disclosed. The needfor a simple, effective early warningmetric is long overdue. Complextechniques for possible fraudrecognition exist, but are usuallydifficult to implement and exact aheavy resource toll – both in skilledquantitative personnel and incomputing requirements. The Bias ratiois a simple, robust technique forevaluating possible deception and maybe easily implemented in simplespreadsheet software. Interpretedtogether with other (standard)statistical coefficients, it could providethe much-needed measurementcurrently sorely lacking in the market.

For more on this topicABDULALI, A. (2006). The BiasRatio: Measuring the Shape of Fraud,Protégé Partners – Quarterly Letter, 3Q2006.AGARWAL, V., Daniel, N. D. andNaik, N. Y. (2007), Why is Santa sokind to hedge funds? The Decemberreturn puzzle! Working Paper, GeorgiaState University.ALGO QUARTERLY, (2009).Operational risk due diligence: Lessonslearned from the world’s greatest snakeoil salesman, Algo First Newsletter,Algorithmics, 1-11.

BERK, J. B. andGreen, R. C. (2004),Mutual fund flows andperformance inrational markets,Journal of PoliticalEconomy, 112, 1269-1295.BOLLEN, N. P. B.and Pool, V. K.(2008), Conditionalreturn smoothing inthe hedge fundindustry, Journal ofFinancial and QuantitativeAnalysis, 43, 267-298.BURGSTAHLER, D.and Dichev, I. (1997),Earnings managementto avoid earningsdecreases and losses,Journal of Accounting andEconomics, 24, 99-126. CARHART, M. M.,Kaniel, R. Musto, D.K. and Reed, A. V.(2002), Leaning forthe tape: Evidence ofgaming behavior inequity mutual funds,Journal of Finance, 57,661-693.DECHOW, P. M.,Richardson, S. A. andTuna, I. (2003), Whyare earnings kinky? Anexamination of theearnings managementexplanation, Review ofAccounting Studies, 8,355-384. 40.DEGEORGE, F.,Patel, J. andZeckhauser, R.(1999), Earningsmanagement to exceedthresholds, Journal ofBusiness, 72, 1-33.DERRIG, R. A.(2005). Newapplications ofstatistics and datamining techniques toclassification and frauddetection in insurance. Wharton School.Online:http://www.google.co.uk/search?sourceid=navclient&hl=en-GB&ie=UTF-8&rlz=1T4GUEA_en-GBGB309&q=%22fraud+indicators%22+statistics+metrics [Date of access:2 February, 2009]GETMANSKY, M., Lo, A. W. andMakarov, I. (2004), An econometricmodel of serial correlation andilliquidity in hedge fund returns, Journalof Financial Economics, 74, 529-609.

HAYN, C. (1995), The informationcontent of losses, Journal of Accountingand Economics, 20, 125-153.KPMG, (2009). Managing MarketRisk, New attitudes, old wisdom.Online:http://www.kpmg.fi/Binary.aspx?Section=174&Item=4966 [Date of Access: 1February 2009]WARING, M. B. and Siegel, L. B.(2006), The myth of the absolute-return investor, Financial Analysts Journal,62, 14-21.


47

Figure 4: Histogram of Madoff’s Fairfield Sentry fund return data.The normal distribution is superimposed over the same data bins.

Figure 5: Histogram of three South African hedge fund strategyreturns: (a) a long-short equity fund, (b) a market neutral fund and(c) a fixed income hedge fund. The normal distribution issuperimposed over the same data bins in each case.

Many investors consider putting their nest egg savings intooffshore investment bonds to take advantage of ‘tax free’ rollup and protection from inheritance tax through trusts.However local tax requirements will still apply and there maybe other restrictions on the way the policy is sold dependingon the residency of the policyholder.

The impact of the global recession has brought increasingattention to the offshore financial services industry andbrought greater attention by governments on the retention ofprecious tax revenues as the impact of the credit crunchreduces the amount of revenue through regular sources.Turning a blind eye is no longer an option and the chances ofloopholes being closed have never been greater.

The 3rd Life Directive in the European Economic Area(EEA) covers 30 countries (EU member states, Norway,Liechtenstein and Iceland) and is designed to allow crossborder trading of life assurance enabling firms to sell policiesin other EEA countries without establishing a branch on whatis known as a ‘freedom of services’ basis. Unfortunately taxrules and other local requirements have not been harmonisedand insurers must abide by the ‘general good’ in each countrywhere the policyholder is habitually resident. It makes nodifference where the sale takes place e.g. a life company basedin the Isle of Man sells a policy through an intermediary inJersey to a Spanish resident (Spanish general goodrequirements apply).

To sell life policies to Spanish residents requires a taxrepresentative based in Spain and translation of policydocuments into Spanish. Just to complicate matters thepolicyholder will soon be able to select the contract law oftheir native state e.g. a UK ex pat resident in Spain couldhave a UK contract however all other general goodrequirements including taxation still apply.

General good also applies to other local requirements.Belgium in particular lays out whole areas of Belgian law inRoyal Decrees that must be compliant with for its residents.Germany does not allow illustrations of with profit policies,Portugal requires a contribution to its insurance institute andLatvia expects firms to participate in its insurance guaranteescheme (IGS) or plan.

Policyholders also expect an insurance guarantee scheme (orplan) to be in place but only 8 EEA countries offer suchschemes for life assurance with very restrictive crossborder coverage. A German policyholder with aUK policy is not covered by the UKFinancial Services Compensation Scheme(plan) and even if the UK firm had aGerman branch it would not be allowed toparticipate in the German scheme. This isprobably in breach of Article 12 of the ECTreaty but so far has remained unchallenged. InSpain branches of EEA offices must contribute to theSpanish IGS but their policyholders are not covered.Many compensation schemes also fail to recognise individualpolicyholders with investments in life policies and treat theinsurer as an investor with limited or no recognition by the

scheme. France allows foreign branches to participate in itsIGS but so far no EU branches participate in the FrenchInsurance Guarantee Scheme (FGAP).

When you multiply these scenarios across many differentcountries it soon becomes uneconomic to sell across the EEAwithout focusing on key markets and imposing strictresidency restrictions on intermediaries. The new PaymentServices Directive will also restrict recognition of life policiescross border to those providing 110% life cover unlike the101% currently offered by many UK life bonds.

Of course the difficulties of the 3rd Life Directive only applyin the EEA but countries outside the EEA have their ownrequirements. Switzerland imposes stamp duty on policies forSwiss citizens and the multiplicity of regimes andrequirements worldwide would require a large team ofregulatory and tax experts to manage effectively. The offshorelife industry in Europe has some very difficult questions toconsider if it is to continue to trade compliantly. The recentG20 conference also focused attention on offshore tax havenswhere tax rates are often considerably less than developedcountries.

Of course the life industry is not the only one affected by thedangers of cross border trading. In one Canadian provinceadditional taxes are charged for non licensed brokers andunauthorised insurers. Whilst they allow them to operate fornon standard risks the costs can be considerable with taxes asmuch as 10% and 20% respectively. The impact of failing tobe aware of these local difficulties can amount to aconsiderable back tax bill to pay and a possible fine when theauthorities find out making it essential to fully investigate thelocal market before going on risk.

For a financial services firm working across differentjurisdictions, it is imperative to manage its regulatoryfootprint. This will begin with identifying where business istaking place and to whom services are being sold. Justbecause a sale takes place in one jurisdiction does notnecessarily prevent it from being subject to the requirementsof another. Often a deep understanding of the requirementsof local law and taxation is essential to avoid the pitfalls ofpenalties and prosecutions for tax violations. As countriesbecome even more sensitive about avoiding tax leakage the

control of such risks will becomemuch greater.

CROSS BORDER TRADINGThis article, written by Anthony J Smith, FCII, Head of Risk & Compliance, Risk Reward Ltd, focuses on why, for afinancial services firm working across different jurisdictions, it is imperative to manage its regulatory footprint.


48

Regulation always makes the samemistake – it looks at what has happenedand designs a regulatory structure tostop it happening again. Of coursethere are two main problems with thisapproach:

1. What happened last time will nothappen next time; and

2. Most of the politicians, regulatorsand reporters really have very littleidea about what happened last timeanyway.

Hearing a prominent reporter from aso-called reputable newspaper referringto the crisis starting in 2008, forexample, is all part of the problem. Ofcourse the crisis did not start with acredit crisis, but with a liquidity crisis,and this commenced in 2004. If youlook at responses from 2008 you arelooking at symptoms not causes, andacting on symptoms may actually makematters worse.

Put at its simplest we need moreregulation like a whale needs a hole inthe head.

International RegulationIn the US there are 47 main regulatorsand probably a load of other minorones. In the UK we have a singleregulator for almost everything. Whichis better? The answer is that they bothhave advantages and disadvantages. Youclearly cannot regulate a major businessby looking at a part that onlyrepresents perhaps 5% of the total. Therisk of multiple regulators is thatsomething gets missed. But the singleregulator may not have sufficient skillsto get into all of the issues of aspecialist area. So what is best?

If we move towards internationalregulators for international firms, that istaking a view that they will somehowdo a better job that is currently thecase. The international regulators will

not be based in any one country andwill take a high level view of matters.They are less likely to understand therole a firm plays in a local market, orthe legal jurisdictional rules that apply.In short they are likely to have theirfindings ignored since they would beinconsistent with those of other firmsin the market – perhaps creating aneven more uneven market.

For us the best system is the leadregulator structure, where the HeadOffice regulators take the lead andcoordinate the activity of subsidiaryregulators – with each regulatorensuring that the firm maintainssufficient capital and liquidity locally toprotect the local market. These are therules that have only just been put intoplace, so clearly should be allowed towork for a while. If we move towards acentral international regulator, we can

expect one of the next problems to becaused by exactly that change.

Capital for StressThere is a lot of nonsense being writtenabout the capital in the system. Iremind you that we started with aliquidity crisis that caused a creditcrisis. There is no suggestion that ifLehman Brothers had 50% morecapital, then it would have survived.Put at its most basic, when thereputation of the firm has beenimpacted (rightly or wrongly), it isgoing to fail and no level of capital islikely to help it. If we allow theregulators to put capital charges ontothe banks at a stress (or near stress)level this will be an unmitigated disasterfor mankind.

The argument goes like this. The bankswill need to have more capital and will

WHERE IS REGULATIONREALLY GOING?HERE WE GO AGAIN. EVERYONE APPEARS TO BE POSTURING BASED ONTHE THINGS WE THINK HAVE HAPPENED AND SO WE NEED NEWREGULATIONS. NEW REGULATIONS FOR OFFSHORE FINANCIALCENTRES. NEW REGULATIONS FOR LIQUIDITY AND STRESS TESTING.NEW REGULATIONS FOR CAPITAL CALCULATION, BONUSES AND THEPRICE OF A CUP OF TEA….


49

therefore not be able to lend, sinceeach loan increases the capital theyneed. The cost of borrowing willincrease and the availability decrease.The increased rates on loans will causemore companies to fail, unemploymentto increase and poverty to follow. Itcannot work and must not be allowedto happen. What is capital for? If it isto guard a bank against a rainy day,then capital rules should be reducednow, not increased. A rainy day? It ispouring outside. Neither the reporters,politicians nor regulators appear toreally understand why we have capitaland what its role really is. Forcingbanks to keep capital that they cannotuse is like buying a painting and leavingit in storage. It does not achieveanything or add to the common good.

Stress TestingAs you will see later the Bank forInternational Settlements (and mostother regulators) has mandated stresstesting. They have not really said whatshould be done, or how much, or evenhow. They just want some. Actuallythey want rather a lot. So how couldthe US government stress test forunemployment be exceeded withinthree months? Do they reallyunderstand what stress testing isabout? I am not sure that they do. Thetool needs to be used carefully and notas a capital calculator. You do not wantthe stress event to happen. If you knowthat there is a tree in the road and ifyou crash into it you will die, will youjust say “Oh Well, Never Mind” as youdrive headlong into disaster? I wouldhope that you might at least brake, orchange direction – avoiding hitting thetree. So you would not need capital forstress testing – you need thinking.More of this later.

More RegulationThere is a call for more regulation –almost anything so long as there is moreof it. The regulators and politicians areforgetting the law of unintendedconsequences: Man that changes rulesneeds to rule the changes. As you makechanges there is greater stress withinthe business caused by changing roles,processes, systems and controls. Someof these will be effective, but other willbe ineffectual. Basically the uncertaintyresulting from change inhibits thecontrol structures, distorts historicresults and trends and can actually masktrue trends that need to be acted upon.

Worse than that, the last problem willnot be the next one. Whatever thefocus of the regulations are this time,

will warn you what the problems will benext time. I would suggest that interestrate volatility, high interest rates and adefault by a major Western country allwould need to be factored into any newregulatory structure. If it cannot dealwith that type of event then it will notprovide the level of protection that weall require.

Salary and Bonus CapsThe greed culture is now workingovertime. Is it true that some peoplewere over remunerated for what theydid? What about footballers or popstars? Do you want to call up WayneRooney and tell him that he is onlyworth £200,000 a year? Banking is notunusual in paying large sums to so-called stars; and in those termscorporate CEOs are definitely stars. Ifyou limit their remuneration in thebanking sector some will pack up,others will go to places where they canearn more and a few will take thereduced remuneration and work justfine. What has that got to do with thecrisis? Do you really think that thebonuses made any difference to theactions taken?

From experience we know that manypeople are actually not motivated bymoney, what they want is recognitionand success. That means that even ifthey were not paid much they wouldprobably have done exactly the samethings. When you look at the newregulations see if they are driven bygreed or malice, or whether they wouldreally make a difference.

What do we need?I would suggest a few changes arerequired:

1. We do not need a longer rule book;instead we need a better rule book.Too much regulation is almostworthless, really being little morethan pointless motherhoodstatements. Other rules go to a levelof detail which is nothing to do withrisk. We need a risk based rule bookthat actually hits the big issues,rather than getting lost in massiveamounts of detail.

2. We need better and more intelligentregulators who have actualexperience of the areas that they arelooking at. Too many junior staffhave been relied upon to do workthat experienced staff need to do.

3. We need enlightened debate that isnot biased through ignorance, self

interest, envy or blind prejudice.This area is too important for thatand reporters in particular need totake heed.

4. The schools need to be part of thesolution providing education intofinancial principles such that keyissues will be better understood.

5. Risk based modelling should driverisk management, regulation,internal and external audit. It shouldbe at the heart of regulation, ratherthan a sometime peripheral figurethat is dragged out only when thereis a problem.

6. The rules should encourage morethinking and less modelling.Spurious data sets that mask realproblems inhibit the ability ofBoards to achieve their objectives.

7. We need to enhance corporategovernance, raising the standing ofinternal audit and non-executivedirectors. We would recommendthat all non-executive directorsshould be required to attendcourses to understand the businessthe are doing and in particularshould be required to attend riskmanagement courses. One non-executive director with riskmanagement expertise should beappointed to the Board to providethe level of independent scrutinythat is really required.

8. The Lead regulator concept shouldbe made to work effectively,requiring formal coordinationbetween regulators.

9. We do not need more transparencyand reporting, instead we needbetter regulation and understanding.A set of 400 page accounts in tinyprint is not transparency; it is purelya hernia for the postman and theend of another forest of trees. Clearinformation that is short, conciseand easily understandable is therequirement.

10.Fair value as it was introduced was adisaster. Fair value is not marketvalue when the market is not fair –neither on the way up, not on theway down. There should be a rulebased on intrinsic value, beingrepresented by expected future cashflows to amend the current ruleswhich clearly do not workeffectively.

WHERE IS REGULATION REALLY GOING? CONTINUED


50

The IFQ is a ground-breaking qualification that covers Islamicfinance from both a technical and a sharia perspective,providing the first international benchmark in the area ofIslamic finance.

It provides delegates with an understanding of the influence ofsharia in a business context and prepares delegates to holdkey positions in the Islamic finance and takaful (Islamicinsurance) industries.

The qualification and training course are appropriate forexisting and new employees and those seeking a career inIslamic finance. Since its launch, the exam has been taken inover 40 countries.

IFQ IFQ ISLISLAAMIMIC FINANC FINANCE QUCE QUALIFIALIFICCAATITIOONN

AND TRAININAND TRAINING COURG COURSESE

Since its inception the IFQ has beenhighly acclaimed as it contributes tothe widening and deepening of theskills of financial practitioners. We areconfident that this third edition willfurther confirm its pertinence to thefinancial industry at large.

Key Features of the IFQ

Provides an essential knowledge of the general principles of sharia (fiqh al muamalat) and itsapplication to Islamic banking and finance.

Covers the different types of Islamic financecontracts and products available.

Examines the practices used in the Islamicfinancial markets and the principles behindinvestment selections.

Employing IFQ holders indicates that a companyis contributing to the development andpromotion of high ethical standards amongst itsstaff.

Initiated and supported by the Central Bank ofLebanon (Banque du Liban).

Awarded jointly by the Securities & InvestmentInstitute (recognised by Ofqual, the UKgovernment education regulator) and l EcoleSupérieure des Affaires (ESA).

Available internationally.

Offered in English and from 2010 in Arabic.

Who Should Attend?

All banking and finance professionals eitherworking within an Islamic financial institution orintending to do so and any other professionalsworking in the field who wish to develop their skillsand understanding of Islamic finance.

� www.riskrewardlimited.com +44 (0)20 7638 5558 � [email protected]

Raed H. CharafeddineFirst Vice-Governor, Banque du Liban

Chairman, Advisory Council for Islamic Finance

The professional qualifications and membership body for the securities and investment industry

60 MoorgateLondon EC2R 6ELUnited Kingdom

Office hours: London (GMT)09.00am – 19.00pm Monday – Friday

telephone: +44 (0)20 7638 5559fax: +44 (0)20 7638 5571

email: [email protected]: www.riskrewardlimited.com

Dennis Cox – CEOtelephone: +44 (0)20 7638 5558email: [email protected]

Lisette Mermod – Commercial Directortelephone: +44 (0)20 7638 5559email: [email protected]

Nick Barcia – New York Officetelephone: 1-914-619-5410email: [email protected]

For further information please contact:

Documents

riskupdate Risk Reward 35COMPENDIUM Update Q2 2009- The... · Union Bancaire Privee. Fauchier Partners manages USD 4.3bn in hedge fund investments and inherited a USD 30m position