The only perfect hedge is in a Japanese garden,” said Eugene Rothberg, a former World Bank treasurer. This quote aptly sums up the reason for the recurrent problems in financial markets.
Every trader and quant seems to think that his model has all conceivable variables built in as he has looked at the relevant data over the last 20-50 years. And then he encounters the perfect storm, which throws up something the model had not expected. Even Nobel economist Myron Scholes, co-creator of the Black-Scholes option pricing model, found this out when his firm Long-Term Capital Management almost brought the US financial system to its knees in 1998, as the markets did not follow the pattern of the previous decades.
In this increasingly complex world of financial services, the role of the risk manager is becoming difficult. Some institutions have broadly defined roles for risk managers. He or she is responsible for all types of risk, an almost impossible task for any individual to handle.
There are different types of risks.
Credit risk: Where you look at the borrower’s ability to pay back his debts based on his cash flow or the value of his assets. However, the flaw in the system is the value placed on the published financial statements, as the world discovered during the Enron and WorldCom fiascos.
Market risk: This is probably the risk which is the most difficult to assess and understand, as the price of assets and liabilities fluctuates based on the daily movements of foreign exchange, interest rates, equities or even credit. Over the last two decades, market risk has been the reason financial institutions as well as companies and investors have taken major hits on their income statements.
Operational risk: Depends on your ability to monitor and process the risks and transactions, which banks take on a daily basis. With banks getting bigger, spreading geographically and processing hundreds of thousands of transactions every day, operational risks will continue to be a cause of concern unless strict checks and balances are put in place, including total separation of front and back office.
Historically, banking losses were predominantly from credit losses, where the borrower did not pay back his borrowings due to a business downturn or the customer intended to defraud the banks all along — or sometimes because of systemic risk.
Market risk has resulted in two of the biggest trading losses in history — for Baring Brothers (which bankrupted the company) and Societe Generale (which recently reported substantial losses due to a rogue trader). In both cases, it was also a case of the failure to manage operational risks. The traders in both banks were able to override or manipulate internal controls which would normally have spotted and prevented the traders from taking such huge trading positions.
Market risks also account for the losses being incurred in the subprime market or as a result of frozen positions in the underwriting of leveraged loans.
The risk management function is normally associated only with financial institutions, but with companies becoming globalized, this is a function which every major corporation should have.
There have been numerous cases of corporate losses. These include Sumitomo Corp., which took huge losses in 1995 as a trader tried to corner the copper market. In 1994, Procter and Gamble was reported to have lost $150 million in derivative positions. Closer home, Larsen and Toubro, ICICI Bank and Hexware Technologies have all reported trading/derivative-related losses. I am sure this is just the tip of the iceberg.
Companies also have to be sensitive about the counter-party with which they have hedged their risks. In Indonesia, during the crisis of 1997, one of the companies had hedged its derivates and trading risks with an investment bank called Peregrine. Neither company survived the crisis.
Why do these losses arise and what can be done? Most of the market losses result from traders taking unauthorized positions as a result of bosses pushing staff to deliver significant jumps in revenue year after year. Offsetting this is the compensation system of bonuses which rewards earnings, but leaves the shareholders holding the bag when losses are incurred. The board has to accept some responsibility in terms of setting the compensation benchmark and how it is to be paid — one-year performance or over three years, and no golden parachutes.
The second question is why you have the breakdown in controls — not just in the financial institutions, but also in the companies where traders/CFOs invest in complex instruments and whose values they have no way of finding out as they don’t have the models, or where a single bank makes the market for such a structured instrument. This is akin to jumping from a plane with no back-up parachute.
Having seen a number of such cycles over the last 30 years as a banker, I would venture that very few institutions follow George Santayana’s dictum: “Those who cannot remember the past are condemned to repeat it.”
Avinder Bindra is CEO of ARX Analytics and Advisory. Comments are welcome at email@example.com