Category Archives: Financial Crisis

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Systemic Risk Management

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On the three-year anniversary of the Lehman Brothers bankruptcy — and with it, the beginning of the financial crisis that threatened a run on at least a dozen major global banks — a rogue trader was discovered to have defrauded his employer, the Swiss bank UBS, of nearly $2 billion.

What’s $2 billion between former friends, you might ask?

Indeed.

$2 billion isn’t going to bring down a bank of UBS’ size. $2 billion isn’t going to ignite another downward spiral of credit payments coming due. $2 billion isn’t going to hurt that badly, even if UBS is now reporting that the incident may cause it to go into the red for the third quarter.

So more than anything, what this undetected fraud highlights is just how poor the risk management still may be at one of the world’s biggest banks. And coincidentally — or perhaps not so much so — the head of risk for UBS was formerly the head of risk for Lehman.

“It’s astonishing given the technology, the systems, the emphasis on risk. UBS has been focusing on it, post-crisis they’ve put more focus on it than a lot of other banks,” the industry source said.

“I’m surprised that this many years after [previous rogue trader] Nick Leeson there are still the Jerome Kerviels of the world and now this one. How does a 31-year-old rack up a $2 billion loss without anybody noticing?”

Others said the crisis showed lax supervision at UBS and threw the spotlight on an industry that will always compel some staff to take excessive risks to keep ahead of rivals.

“No rogue trader works in a vacuum, and UBS’s management must have taken its eye off the ball to allow a trader to operate on this scale without sufficient supervision and without the systems to monitor his trades,” said Simon Morris, a partner at UK law firm CMS Cameron McKenna.

Worse still is the fact that UBS is unlikely to be the one isolated financial firm that has dragged its feet in implementing better protocols to avoid, or at least discover, threats. No, many of its peers are likely also not yet as far along as they should be — three years later.

Fortunately, some of the laws mandated by the Dodd-Frank financial sector reform act are starting to kick in. It remains to be seen if these new rules will help, but one of them mandates companies to create a plan that will help officials (namely, the FDIC) unwind and deconstruct complex transactions in the event they go belly up.

Submitting these plans, which have been called “corporate living wills,” is essentially giving the government “Tell Me How You Will Fail” blue prints.

The New York Times blog Deal Book breaks down the concept.

The basic idea is simple: big financial companies have to submit plans that explain how they would structure a future bankruptcy case or orderly liquidation authority proceeding if they were failing. The plans have to be written for two scenarios: one in which a financial institution alone fails, and one in which it fails as part of a broader crisis. In addition, financial institutions would have to disclosure their exposure to other significant financial companies.

The wrinkles start to develop when you see that the rules provide that the plans have to be made with an assumption of no governmental funding. That makes sense given how Congress has restricted the Federal Reserve’s §343 powers as lender of last resort, but it is not very appealing, especially for the systemic crisis scenario.

If not the government, precisely who is going to provide funding when the bankers are in severe trouble? And how precisely do you pay for a bankruptcy case — even a Chapter 7 liquidation case — with no funding? It probably involves the equivalent of leaving a failing bank in a vacant lot in Newark.

As Deal Book blogger Stephen Lubben notes, the schedule of this whole exercise means that finalized plans may not be on file with the FDIC until 2014. That, as well as more fundamental issues some have raised, make this an imperfect method to manage systemic risk in the financial system.

But considering that the government was making no attempt to manage systemic risk in any systematically way prior to the crisis, this can at least be considered progress.

As for whether or not it is a solution to the next global financial crisis that threatens to drag the world into a replay of the Great Depression, hopefully we will never have to find out.

The New Era of Regulatory Enforcement — Comply or Go Directly to Jail

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[Each year, the best Canadian risk managers gather to discuss the state of the discipline at the RIMS Canada Conference. The 2011 incarnation is taking place this week in Ottawa so I will be reporting from here for the next few days.]

“The possibility of doing jail time is real from the board room to the warehouse floor,” said Jay Cassidy yesterday at the 2011 RIMS Canada Conference, summing up the new anti-corporate fraud stance taken by U.S. Attorney General Eric Holder in recent years. “It’s not going to be a slap on the wrist. It’s gong to be very personal. And [they] will put you in jail.”

This was the key takeaway from a Monday afternoon panel discussion at the conference, which was focusing on regulatory expansion and led by Cassidy, senior vice president at Marsh Canada. Things have changed and rules created by Dodd-Frank and the Foreign Corrupt Practices Act will have wide-ranging implications — and penalties — for any offending companies.

Another trend is that regulatory agencies are increasingly working together and employing new tools they haven’t used in the past. The SEC and Department of Justice are reaching out to the FBI, for example, for expertise and resources. They have begun wiretapping when it is deemed necessary. In all respects, the regulatory bodies are widening the scope of what they can use to investigate.

One aspect of the reform receiving a lot of coverage is new whistleblower incentives. Now, anyone who reports a company for rule-breaking may be eligible to pocket up to 30% of the sum that officials deem was ill-gotten. Even if the offense is only valued at $1 million, that’s a nice little bonus for the whistleblower. Imagine if it is $1 billion.

Given this, it’s not hard to see why more people might become tipsters for the government. And according to the panelists, the Department of Justice is now expecting to receive upwards of 30,000 tips per year.

This may not lead to more major fraud rulings, however.

“Whisteblowers have always been principles-based more than looking for some sort of monetary pay-off,” said Ashley Beales, vice president at Berkley Professional Liability. “It’s usually that they just can’t keep quiet anymore.”

The money will likely lead to more tips and perhaps the discovery of more minor violations, he said, but on the highest level, Beales doesn’t expect a new wave of huge violations to start flooding out. At least not to enough of a degree that would significantly alter the D&O market, something that is generally affected by major claims. “Significant fraud always bubbles to the top [regardless of incentives],” he said. “This volume will be more noise than substantive.”

But even if it is merely noise, that doesn’t mean companies are off the hook. “Even if it’s not a legitimate claim and the SEC comes knocking on the door … you don’t tell these people ‘Go away,'” said Laura Markovich, partner at Sedgwick. “They won’t. They’ll come back with a subpoena.”

And just dealing with false claims can run up a big bill quickly. “Lawyers are expensive,” said Cassidy, noting that this is even truer for Wall Street firms. “And New York lawyers are … well … they’re very expensive.”

In regards to increased Foreign Corrupt Practices Act enforcement, the panel said that there will be two major aspects for companies to consider: (1) anti-bribery provisions and (2) the accounting part, which will mandate the need for better internal controls.

The first factor may be especially important for Canadian companies. If they have operations in the United States (or in some cases, even if they don’t) they will be at risk of regulator action. And Cassidy cautioned that this may be difficult to navigate given the fact that Canada is increasingly becoming a resource-based economy. He mentioned that in other locations where this has been the case (Cassidy listed parts of Africa, Russia and Kazakhstan), corruption and bribes have been more typical than, say, in economies in which retail or services drive the economy. “Historically, business has been done a little differently than what we might find acceptable [in Canada],” said Cassidy.

Canada is certainly not Nigeria. The business climate and legal culture would never allow for pervasive bribery and other illegal behavior. So for those in the energy and resources sector, the obvious solution is to remain above board in all operations.

But I do image that many companies will find that, when shipping oil and coal throughout the world, staying true to your ethics — and even within the code of the law — can sometimes be easier said than done.

[Correction: this post originally listed Ashley Beales as working for Canada Berkley. It has been update to reflect the fact that the company is called Berkley Professional Liability. Apologies.]

Justice Department Investigation of S&P

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The Justice Department is investigating Standard & Poor’s for improperly rating the garbage mortgage-backed securities that tanked the economy once the world caught on that they were toxic assets.

The anonymous folks who leaked this info to the press claim that the inquiry began prior to S&P’s downgrade of U.S. debt, but many have speculated that the fervor and depth of the probe has ratcheted up since the nation lost its AAA-status.

Either way, the law dogs are — finally — poking around in the ratings world.

he Justice Department has been asking about instances in which the company’s analysts wanted to award lower ratings on mortgage bonds but may have been overruled by other S.& P. business managers, according to the people with knowledge of the interviews. If the government finds enough evidence to support such a case, which is likely to be a civil case, it could undercut S.& P.’s longstanding claim that its analysts act independently from business concerns.

It is unclear if the Justice Department investigation involves the other two ratings agencies, Moody’s and Fitch, or only S.& P.

Any inquiry should of course involve looking at all three. Each overrated the used diaper mortgage-backed securities to a baffling degree. Whether or not it was incompetence or something more insidious is really the only question, I have. I presume they are capable of both.

But if this investigation focuses solely on S&P then it falls even more into how one talking head on MSNBC’s The Daily Rundown described it: more of a Washington story than a Wall Street one.

Honestly, the only weird thing about hearing today about an investigation going on right now is that it was something I expected to hear in 2008.

In related news, and not just to toot our own horn, but I would feel remiss not to mention that our Risk Management magazine cover story this month was titled “The Future of Ratings” and examines “how rating agencies gained so much power, helped tank the economy and figure into the future of risk assessment.”

I’m not going to pretend that I knew just how much play rating agencies would be getting in August when I commissioned the piece a few months ago. I’m many things, but clairvoyant is not one of them. But the piece speaks to many of the questionable issues surrounding the ratings world that have been curiously dormant in the mainstream media for years until recently.

A wonderful writer, Lori Widmer, did a fine job so please do give it a read.

One Reason the SEC Can’t Regulate Wall Street

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Regulators, particularly those within the SEC, took a lot of criticism for their inability to prevent the financial crisis in 2008. And rightly so. The complex CDOs and credit default swaps were all poorly regulated and this whole cottage industry that arose to, in essence, gamble on the real estate industry brought the global economy to the brink.

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So feel free to continue piling on the regulators.
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I’m sure I will.

But sometimes you see something that adds a little more perspective.

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And today that comes from Forbes, which published the well-titled piece “10 Wall Street Expenses That Make The SEC’s Budget Look Pathetic” in response to the ongoing Washington debate over the size of SEC’s budget. (President Obama wants to raise it from the current $1.1 billion to $1.4 billion while House Republicans want to chop $25 million off the current total, according to Forbes.)

It isn’t apples-to-apples, but their list makes you wonder how always-behind-the-times-anyway bureaucrats could ever hope to compete with the savvy titans of the Street. The most glaring comes in looking at the $4 billion JPMorgan maintains for its litigation reserves alone. As Forbes writer Halah Touryalai puts it, “Yes — that means the money JPM is saving so it can fight or settle lawsuits is 4x the size of what the SEC has to regulate the entire securities industry.”

Kind of like taking a spork to a gun fight.