Section 4
Adding Value through Risk Management
SECTION OVERVIEW
Martin Upton
When I joined the treasury of a major UK financial services company in 1987 there were no risk managers in the division. The treasury was staffed by the dealers in the “front office” and a small “back office” team. The division employed only one primitive computer system. This provided a valuation of the holdings of government securities, which constituted only a small proportion of the total assets held in the company's investment portfolio.
At the end of trading each day the front office staff helped out the back office team by manually updating portfolio records and valuations. A PC-based valuation model was introduced a few months after I joined, albeit programmed by one of the dealers!
The world had changed seventeen years later when I left the company. The treasury division then had a large risk management department (known as the “middle office”) with staff numbers matching those in the front office. The division also had its own legal and compliance team. Strict segregation of duties applied: front office staff were denied free access to the middle and back offices by the introduction of key card systems. The front office reciprocated by similarly controlling access to the dealing room by the middle and back office staff. Remuneration levels for middle office staff were rising to match those of the dealers. Extensive use of treasury computer systems was made to ensure correct market valuations and compliance with the risk management controls on market, operational and credit risks. The Financial Services Authority had a regular dialogue with the division and periodically visited to assess the technical competence of treasury management and the soundness of the control infrastructure. In the wake of these developments – that matched those elsewhere in the financial services industry – it was not uncommon to hear dealers and brokers comment that treasury divisions had been taken over by the risk managers.
Looking back at the emergence of the culture of risk management it is tempting to ascribe it as a reaction to the series of high profile treasury calamities of the past twenty years. In 1991, activities by UK local authorities in derivatives were deemed unlawful (and hence unenforceable) after a protracted legal case that made it all the way to the House of Lords. The judgement triggered a plethora of litigation as parties to the voided derivative contracts sought financial restitution.
Seven years on came the demise of Barings Bank as a result of losses on derivatives trading incurred in its Singapore subsidiary. The speed of the collapse of Barings staggered the financial markets: as one former senior employee remarked, “on the Friday before it happened we were arranging international loans; on the following Monday the milkman was refusing to deliver to us”!
The fall-out from the collapse of Barings probably helped to encourage changes to banking supervision – with the Government moving this from the Bank of England to the newly formed Financial Services Authority in 2000. Additionally the collapse spawned extensive guidance from regulators and professional bodies about risk management practices and standards. Fundamentally, though, the lesson from Barings was a simple one – front and back office activities need to be segregated to ensure that dealers cannot conceal their trading positions. Indeed inadequate segregation of responsibilities was also at the heart of the huge trading losses incurred by the Allied Irish Bank's US subsidiary Allfirst in 2002. One of the articles in this section looks at this episode in detail.
The collapse of the US energy company Enron in 2001 also showed that there were major lessons in risk management to be learnt. Enron did employ risk managers and extensive risk management systems. The problem appears to have been that senior management did not sufficiently empower the risk managers to rein in the company's trading activities. Again the demise of Enron and subsequently WorldCom prompted legislation in the US in the form of the Sarbanes-Oxley Act of 2002 requiring, inter alia, closer understanding and stewardship of company financial risks by senior management.
The above are only a sample of the recent episodes of organisations failing in the task of risk management. These have been very influential in the direction and pace of the growth of risk management around the globe. In all probability, though, this evolution in risk management would have happened without them. One reason to believe this is that the growing globalisation and the associated increase in the complexity of the financial activities of organisations, particularly in their treasury transactions, has necessitated a more considered and fully resourced approach to risk management. For example, at the company for whom I worked the move from being a solely sterling-based operation to a multi-currency treasury necessitated measuring and managing foreign exchange (FX) exposure. A second factor supporting the evolution of risk management has been the development of computer systems – and the capacity of these to be built to produce bespoke solutions for organisations. These now provide the means of applying active risk management and the monitoring of controls in a live environment without inhibiting the pace of trading activities in the front office.
The articles selected for this section are intended to provide coverage of the main financial risks facing organisations – interest rate, foreign exchange, contingency, operational, refinancing and credit risk – and analysis of how risk management techniques can be employed to manage them.
Foreign exchange risk – the exposure to potential losses from changes in exchange rates – is well understood and is a financial risk for many organisations. The impact of “operating” (or, as also termed, “economic”) exposure is less well understood. The article by Donald Lessard and John Lightstone, “Operating Exposure”, examines this subject and helps us understand that this is a further – and in many ways more complicated – facet to foreign exchange risk than that arising through “transaction” and “translation” exposures.
The article by Sharon Burke, “Currency Exchange Trading and Rogue Trader John Rusnak”, details the foreign exchange transactions that resulted in losses of US$691 m by Allied Irish Bank's US subsidiary Allfirst in 2002. The article is more than just a catalogue of bad – and false – FX transactions and options trades: it should be compulsory reading for anyone managing or auditing a treasury function. The article documents the operational weaknesses in Allfirst's treasury department that provided the fertile environment for a “rogue trader”. The flawed FX trades that led to the losses could not have happened within a well controlled treasury. Read the article and see if you agree with me.
We then move on to look at the current favourite “tool” of risk managers worldwide: “Value at Risk” or “VaR”. The article by Christopher Culp, Merton Miller and Andrea Neves, “Value at Risk: Uses and Abuses”, provides not only a lucid explanation of VaR methodology but also a critique of its usefulness for managing interest rate and other risks. The article assesses how well the technique would have helped avoid the financial calamities (or “derivatives disasters” as the authors call them) that befell Procter & Gamble, Barings, Metallgesellschaft and Orange County.
The next article, “Learning to Live with Fixed Rate Mortgages”, is my own contribution, and looks at interest rate risk management in practice by studying the evolving approach to hedging mortgage products in the UK financial services industry. In addition to examining the use of various hedging instruments, like swaps and options, the article demonstrates an evolutionary approach to risk management where methods of hedging are refined in the wake of growing experience about customer activity. Hedging efficiently here involves second-guessing customer behaviour – a difficult task since such behaviour is often financially irrational!
We then move on to examine the growth area in risk management since the 1990s: credit derivatives. “Credit Derivatives” by John Kiff and Ron Morrow provides a succinct and intelligible examination of this complex subject and identifies the advantages and disadvantages of these risk management tools.
The section concludes with two inter-related case studies. Case Study 9 is an extract from the London Financial Times by Jenny Wiggins, “The Journey to Junk”. It explores the financial problems encountered by the US car company General Motors. The article identifies the issue of refinancing risk, looking at the impact on the cost and availability of funds of a significant reduction in credit ratings. This case study should be read in tandem with Case Study 10, “Who Rates the Raters?”. This extract from The Economist looks at the power of rating agencies and the way they react to the credit developments in the organisations they rate.
Whatever the progress that has been made in financial control by the risk management “revolution” over the past twenty years, future changes to practices seem inevitable if only because it is naïve to believe that current systems have eradicated the potential for any future financial calamities.