Category / Reputational Risk

A great title: Jamie as Lance November 4, 2013 at 8:33 am

I don’t agree with much in this post, but the title is so good that I have to quote it anyway:

Jamie Dimon, the Lance Armstrong of Finance

A good title doesn’t just provide a bite-sized synopsis, it raises questions by itself: and this one does just that. It’s compelling not because it is true – it isn’t – but because it makes the burden of proof clear.

The law and the window* May 27, 2013 at 1:10 pm

Laws are only imperfectly aligned with public morality. We (nearly) all agree, for instance, that theft is wrong, but a substantial number of people don’t see speeding as immoral. Moreover, even when something is legal, it isn’t necessarily moral. Indeed, as Louise Weinberg points out, there is in US law “a rather large legacy of judicial opinions struggling with immoral law—the old cases on slavery”.

Eventually, if the gap is big enough, the law is changed. Slavery was abolished, after all. This process is neither certain nor swift, but it is a foolish corporation who gets on the wrong side of it. Behaving legally does not necessarily protect against reputational damage, as Barclays has found out†. What you don’t want to do, then, is wait until the day before the law changes to get your house in order.

It’s therefore odd to hear that Google’s Eric Schmidt

has continued to defend his company’s tax position, saying if Britain wanted to collect more tax, it should change the law. In a phrase less snappy than the more celebrated “don’t be evil”, Schmidt said Google had “a fiduciary responsibility to our shareholders”

Yes, he does have a responsibility; but that extends to not destroying the company’s reputation too. Now obvious there is a calculation here – will outrage about tax structuring go away? My guess is that it won’t, and that companies that behave legally but in a way that comes to be generally seen to be unethical, will suffer. We can’t yet predict if current events represent a paradigm change in public morality, of course; nor can we say how Google or Apple or any of the others will be seen in future. But Schmidt and his peers have a duty to at least ask themselves the question. As Jonathan Weil says (apropos Apple), tax structuring may soon be seen as indicative of a more general lack of trustworthiness. That is something that no manager should accept lightly for investor trust, once lost, is not easily regained. You quickly become the unpleasant and unacceptable face of capitalism. Companies like Google and Apple, which desperately need to be seen as hip, should think very hard before they risk carrying that label.

*That’s the Overton window.

†Repeatedly: you’d think after the apartheid scandals they would treat more carefully, but no, there was Libor, and tax structuring, and mis-selling and… They weren’t the only ones, of course.

Today’s detention April 10, 2013 at 6:09 am

Go and read Lisa’s excellent post on Pat Hagan’s skills in titling emails and optimising capital.

When is it better not to plan? January 29, 2013 at 6:50 am

The FT reports that BofA is moving the old Merrill international derivatives business back to London. Long time followers of this story will remember that this used to be booked in London, then was moved to Dublin as a tax arb. The London vehicle then lost more money than you can shake a stick at in the credit crisis, generating $8B of deferred tax assets according to the FT. These DTAs will not be part of capital in Basel III (why they ever were has more to do with Japanese sensibilities than prudent regulatory practice), so BofA now needs to make money in London in a hurry. Hence the move.

One can only wonder how much this Dublin zig zag cost, not just directly but in management time. If the firm had not played tax games, ultimately to little purpose, it would not only have saved money, it would not have had to try to construct a plausible case that its international derivatives business was run out of what is, with the best will in the world, hardly a major financial centre*. One of the lessons of this is that optimization in the presence of uncertainty is difficult, and sometimes not worth attempting. Tax planning for an investment bank that not only deprives a country of significant revenue it would otherwise receive but also relies on actually making money is not just in my view immoral; it is also dangerous.

One wonders, by the way, what the impact of this entity restructuring on BofA’s living will. The removal of Irish regulators will presumably help if, as the FT separately reports, living wills now need to assume a lack of cooperation between supervisors.

Tellingly, the Guardian story on this reports that “decision does not involve moving any individuals as the physical trading of derivatives was conducted out of London”.

Investment bankers and other sharks May 30, 2012 at 9:31 am

From the usually excellent TED, a nicely phrased three sentence argument for introducing compulsory ethics training for investment bankers:

…giving access to IPOs at 10 to 15% discounts to fair value is valuable currency for us to share with investors who trade with us, direct business to us, and generally bolster our bottom lines. We are in business, after all, and we have every right to treat some customers better than others if it promotes our own welfare. This is not moral corruption, it is business.

Um, no. It is how business has been done in investment banks for many years (as John Hempton says), but it is also fundamentally corrupt. The fact that TED can’t see this isn’t particularly a comment on him; it rather reflects a business that is in need of massive cultural change. ‘Best execution’ and ‘fair access’ aren’t nice pieces of marketing that should be more honoured in the breech than in the observation: they are the foundation of a fair market. Giving non-public price sensitive information to your friends and contacts or letting them buy in to a hot IPO – whether in precise detail legal or not – is simply unethical. If investment bankers fail to realise how odious this conduct looks to society and as a result don’t reform themselves (which seems to me likely), then society will in due course do the reforming for them. When that happens many of today’s sharks will be on the rubbish heap if they are lucky, and in jail if they are not.

Shark on the rubbish heap

Floating carcus ahoy May 11, 2012 at 9:20 am

When Magellan emerged from the strait that bears his name into the Pacific ocean, he thought that he was only a few days sailing from Portugal and home. Good try, but no cigar. A similar navigational issue seems to be plaguing folks over last night’s $2B JPMorgan loss. Here are some things we can, and cannot conclude from this ‘egregious’ loss.

Update. FT alphaville makes a similar point about the difficulty of identifying a ‘good’ hedge here.

Tax structuring and reputational damage February 27, 2012 at 6:25 pm

Back in March 2009 I wrote:

The Guardian had another set of articles on Barclays’ tax structuring group yesterday. The point is not whether the practices of this group are legal. Some may be; some are borderline; some may not be. The point is the continuing reputational damage being done to the Bank …

And now, behold, that damage continues. From the BBC:

Barclays Bank has been ordered by the Treasury to pay half-a-billion pounds in tax which it had tried to avoid…

Announcing the crackdown, Exchequer Secretary to the Treasury, David Gauke, said the bank should never have devised the schemes in the first place…

Mr Gauke told BBC Radio 4′s Today programme that the experience of Barclays showed that the system of compulsory disclosure for legal tax avoidance schemes was working.

“They have got caught, they disclosed this information, the HMRC has acted very quickly, there will be no benefit to the bank, they are clearly taking a substantial reputational hit and we have demonstrated that banks are simply not going to be able to get away with it,” he said.

The culture has clearly changed from the Blair/Brown years where, sadly, tax avoidance was all too acceptable. If the banks have any sense, they will be doing very significant due diligence before enacting any substantial tax ‘optimization’ transactions in future.

The anatomy of a solvency/liquidity spiral December 13, 2011 at 3:58 pm

I’m reading the FSA report into the RBS failure (so you don’t have to, and because I griped about it not yet being out last week, so I can’t really ignore it). I’ll post in coming days on various aspects of this long and juicy document, but for now let me concentrate on what I think is clearly the mechanism by which RBS failed: a solvency/liquidity spiral.

First, some quotes from the report.

RBS did not have a solvency problem.

“Many accounts of the events refer to RBS’s record £40.7bn operating loss for the calendar year 2008. But that loss is not in itself an adequate explanation of failure. Most of it indeed had no impact on standard regulatory measures of solvency:

  • Of the £40.7bn loss, £32.6bn was a write-down of intangible assets, with impairment of goodwill contributing £30.1bn. Such a write-down signals to shareholders that past acquisitions will not deliver future anticipated value. But in itself, it had no impact on total or tier 1 capital resources, from which goodwill had already been deducted.
  • In fact ‘only’ £8.1bn of the £40.7bn (pre-tax) operating loss resulted in a reduction in standard regulatory capital measures.

Given that RBS’s stated total regulatory capital resources had been £68bn at end-2007, and that it raised £12bn in new equity capital in June 2008 (when the rights issue announced in April 2008 was completed), an £8bn loss should have been absorbable.” (Page 38)

RBS had a liquidity problem…

“The immediate driver of RBS’s failure was … a liquidity run (affecting both RBS and many other banks)… it was the unwillingness of wholesale money market providers (e.g. other banks, other financial institutions and major corporates) to meet RBS’s funding needs, as well as to a lesser extent retail depositors, that left it reliant on Bank of England ELA after 7 October 2008.” (Page 43)

“The vulnerabilities created by RBS’s reliance on short-term wholesale funding and by the system-wide deficiencies were moreover exacerbated by the ABN AMRO acquisition” (Page 46)

… which was driven by concerns about its potential insolvency

“Potential insolvency concerns (relating both to RBS and other banks) drove that run.” (Page 43)

In other words, people were not sure RBS was solvent (even though it was)

“In the febrile conditions of autumn 2008, however, uncertainties about the asset quality of major banks and the potential for future losses played an important role in undermining confidence.” (Page 126)

“The inherent complexity of RBS’s financial reporting from end-2007, following the acquisition of ABN AMRO via a complicated consortium structure, also affected market participants’ view of RBS’s exposures.”

“It is clear that RBS’s involvement in certain asset classes (such as structured credit and commercial real estate) left it vulnerable to a loss of market confidence as concerns about the potential for losses on those assets spread.” (Page 135)

A significant factor in this was that RBS was seen to be too optimistic about what its assets were worth

RBS marks vs ABX

“Deloitte, as RBS’s statutory auditor, included in its Audit Summary report to the Group Audit Committee a range of some £686m to £941m of additional mark-to-market losses that could be required on the CDO positions as at end-2007, depending on the valuation approach adopted… a revision of £188m was made to the valuation of these positions and was treated as a pre-acquisition [i.e. pre-ABN acquisition] adjustment. No other adjustment was made.

Deloitte advised the Group Audit Committee in February 2008 that an additional minimum write-down of £200m was required to bring the valuations of super senior CDOs to within the acceptable range calculated by Deloitte… The Board agreed that additional disclosures should be made in the annual report and accounts, but supported the view of RBS’s management that no adjustment should be made to the valuation.” (Page 150)

“those exposures [i.e. CDO positions] became a focus of concerns by market participants and thus played a significant role in undermining confidence in institutions active in these areas… RBS’s relatively high valuations of super senior CDOs were scrutinised by market comment in early 2008, and there was concern among market participants that further write-downs would be needed, at a time when RBS’s low core capital ratio was already a source of market comment.” (Page 151)

To conclude then

Liquidity risk and opaque/inadequate disclosures, which give rise to concerns about possible insolvency, are enough to doom a bank even if it actually remains solvent.

There will (I know, I know) be more on this tomorrow.

Linkfest October 18, 2011 at 8:25 pm

The paper will be posted tomorrow. Meanwhile…

  • Bloomberg reports ‘Interest-rate derivative users may have to set aside at least $1.4 trillion in margin payments under new rules mandated by the U.S. Dodd-Frank Act, according to research firm Tabb’. That is a lot of extra margin.
  • Also from Bloomberg, unsurprisingly given the prior item: ‘Demand to transform non-standard collateral for use at swaps clearinghouses is set to grow as new rules take effect for the $601 trillion over-the-counter derivatives market, according to CME Group Inc. (CME)’s Craig Donohue’.
  • In similar vein, it is hardly surprising that ‘Banks and insurers have hit back at the UK regulator’s moves to block a new form of funding transaction [i.e. collateral swaps] between banks and insurers… Phoenix Group and Lloyds Banking Group have each had transactions blocked [by FSA]‘, the Financial Times reports.
  • Next a fascinating post from the Physics of Finance on what really moves markets when HFT is possible. The key result:

    As the efficient markets hypothesis (the “weak” version, at least) claims, market prices fully reflect all publicly available information. When new information becomes available, prices respond. In the absence of new information, prices should remain more or less fixed.

    Striking evidence against this view comes from studies (now almost ten or twenty years old) showing that markets often make quite dramatic movements even in the absence of any news… stronger evidence comes from studies using electronic news feeds and high-frequency stock data. Are sudden jumps in prices in high frequency markets linked to the arrival of new information, as the EMH says? In a word — no!

  • Finally, my favourite, also from Bloomberg, a story about Morgan Stanley’s foray into Ukrainian farming. Yes, when times are good, investment banks really do think that they can do anything.

Banking on the states September 21, 2011 at 6:11 am

The Aleph Blog has an interesting if ultimately unworkable suggestion: Hand Banking Regulation Back to the States.

First, to be charitable, why this could be a good idea:

  • As the Aleph blog says, ‘It is a lot easier to beat one gorilla than 50 monkeys’. Certainly if there were 51 state banking commissioners, then some of them (by accident if nothing else) would get banking regulation right.
  • All of the state banks would be smaller and hence less likely to be too big to fail.
  • Regulatory capture may be less likely.

The problem is none of these actually work as well as they might at first seem to.

  • If there were 51 state banking commissioners, then some of them will get banking regulation wrong, too. And the biggest banking activities will migrate to those states. You can be sure that someone will want the prize of, say, Citi’s large industrial loan group, and they will relax regulation to get it.
  • The banks in New York and California will still be scarily large, especially if (as is very likely) treasury activites for all the group banks are run from New York. The S&Ls were moreover individually not too big to fail, but that did not stop the bailout.
  • I think regulatory capture is more, not less likely will small often less well informed regulators. Certainly US insurance regulation, which is a state competance (I use the word loosely), did not stop the issues at the monolines.

Diversity is good if it makes the system more robust. It is less good if it just encourages risk to concentrate at the weak points. Sadly moving bank regulation back to the states would be a dangerous and retrograde step.

Conflicts of interest in securitisations: the SEC starts to act September 20, 2011 at 6:44 pm

There is an encouraging new notice of proposed rule making from the SEC regarding conflicts of interest in securitisation. The proposed rule would prevent sponsors of such deals from betting against them. It would moreover prohibit them from structuring deals whose primary motivation was to allow others to go short. (See here for comment from the NYT and here for the text of the proposed rule.)

Specifically

… a securitization participant would be prohibited from profiting from the decline of an ABS it helped to create (assuming that the conflict would be important to a reasonable investor), even if that securitization participant did not intentionally cause, or increase the likelihood of, such decline.

This would cover deals like Abacus where the motivation of selling the securities was to allow 3rd parties to short the underlying.

On a first read (the text is 118 pages long), the proposed rule seems more or less reasonable. While actively prohibiting securitisation sponsors is a good start, there is a need for a much more substantial retention rule too. I would require both originator and distributor of any securitisation to take a 20% vertical slice in the deal. (Compare this with the 5% current requirement.) In a second level CDO of ABS, there would be two distributors; that of the original ABS and that of the CDO tranches: each of these would have to retain 20%. This goes much further than preventing conflicts of interest: it actively aligns interests between distributor of the deal and buyers of the ABS.

It makes sense to prohibiting deal sponsors or originators from shorting the deal. But what about third parties? Here I am less convinced. If I know that a third party (Paulson, say) has created the deal in order to short it, and I still buy it, isn’t that my problem? I wouldn’t make it illegal: I would just say that buyers need to know all the facts behind the deal including its motivation and the presence of any shorts. So disclosure should resolve the issues around third party shorts. Of course, reputationally, few originators would want to bring a deal to market where they had to disclose that the deal motivation was to facilitate a short, but that that is another matter entirely.

Corporate psychiatry September 4, 2011 at 10:50 pm

There has been a meme floating around in the last few years of corporate psychopathy. Actually there are two ideas here: co-workers as (potential or actual) psychopaths; and corporations as psychopaths. It is the latter I find interesting.

Let me explain. In the US at least, corporations have had many of the rights of natural persons for many years. The most famous example of this is the recent supreme court decision relating to election funding (specifically striking down provisions in the McCain–Feingold Act that prohibited all corporations and unions from broadcasting “electioneering communications”).

So, if corporations benefit from many of the rights of people, shouldn’t they be similarly judged by their acts?

DSM V, the latest edition of the American Psychiatric Associations’ Diagnostic and Statistic Manual for Mental Disorders, proposes a number of criteria for antisocial personality disorder:

  1. Significant impairments in personality functioning manifest by:

    1. Impairments in self functioning (a or b):

      1. Identity: Ego-centrism; self-esteem derived from personal gain, power, or pleasure.
      2. Self-direction: Goal-setting based on personal gratification; absence of prosocial internal standards associated with failure to conform to lawful or culturally normative ethical behavior.

      AND

    2. Impairments in interpersonal functioning (a or b):
      1. Empathy: Lack of concern for feelings, needs, or suffering of others; lack of remorse after hurting or mistreating another.
      2. Intimacy: Incapacity for mutually intimate relationships, as exploitation is a primary means of relating to others, including by deceit and coercion; use of dominance or intimidation to control others.
  2. Pathological personality traits in the following domains:
    1. Antagonism, characterized by:

      1. Manipulativeness: Frequent use of subterfuge to influence or control others; use of seduction, charm, glibness, or ingratiation to achieve one’s ends.
      2. Deceitfulness: Dishonesty and fraudulence; misrepresentation of self; embellishment or fabrication when relating events.
      3. Callousness: Lack of concern for feelings or problems of others; lack of guilt or remorse about the negative or harmful effects of one’s actions on others; aggression; sadism.
      4. Hostility: Persistent or frequent angry feelings; anger or irritability in response to minor slights and insults; mean, nasty, or vengeful behavior.
    2. Disinhibition, characterized by:
      1. Irresponsibility: Disregard for – and failure to honor – financial and other obligations or commitments; lack of respect for – and lack of follow through on – agreements and promises.
      2. Impulsivity: Acting on the spur of the moment in response to immediate stimuli; acting on a momentary basis without a plan or consideration of outcomes; difficulty establishing and following plans.
      3. Risk taking: Engagement in dangerous, risky, and potentially self-damaging activities, unnecessarily and without regard for consequences; boredom proneness and thoughtless initiation of activities to counter boredom; lack of concern for one’s limitations and denial of the reality of personal danger.
  3. The impairments in personality functioning and the individual’s personality trait expression are relatively stable across time and consistent across situations.
  4. The impairments in personality functioning and the individual’s personality trait expression are not better understood as normative for the individual’s developmental stage or socio-cultural environment.
  5. The impairments in personality functioning and the individual’s personality trait expression are not solely due to the direct physiological effects of a substance (e.g., a drug of abuse, medication) or a general medical condition (e.g., severe head trauma).

OK, let’s do some diagnosing.

A1 is pretty straightforward. Most corporates pass a or b or both.

A2a is slightly more difficult, but again many corporates pass, while A2b is pretty much the definition of being an employee.

B1 is harder. A diagnosis for a corporate would have be based on a or c, but certainly many PR/investor relations/government affairs groups have an element of B1a about what they do, while B1c can be met simply by the pursuit of profit at the expense of (most) other things.

I would not argue B2a or b are common in corporates, so we need B2c to get a diagnosis. Sadly (or fortunately depending on your point of view), that is not easy either. Yes, corporations take risk, but typically not unnecessarily’ and without regard for consequences. Moreover, while some display ‘a lack of concern for [their] limitations’, they at least try not to. That is what risk management is about. So it seems we stumble on the requirement for disinhibition in our diagnosis.

C and E are straightforward passes for many corporates, but D is difficult too as, frankly, the way corporates behave is normative, at least in North American culture. So, reluctantly, while I think that a lot of what corporates do is antisocial, it would be hard to make a case for involunatry commitment (or sectioning, as we call it in the UK) under the DSM V criteria for antisocial personality disorder. Badly behaved, yes; psychopaths, (mostly) no. Before you get too comfortable though, check out the criteria for Narcissistic Personality Disorder and Personality Disorder Trait Specified: these are a lot easier for corporates to pass…

Model risk and your friendly local regulator July 20, 2011 at 1:02 pm

From a fascinating article at AllAboutAlpha (HT FT Alphaville):

[There was a] settlement early this year between the Securities and Exchange Commission (SEC) and the AXA Rosenberg Group LLC (ARG), along with other entities affiliated with ARG…

The specifics of the problem alleged by the SEC turn on the distinction between Barr’s [an affiliate of ARG's] Risk Model proper, and a separate system, called the Optimizer, a program that took data generated by the Risk Model and used it to recommend an optimal portfolio for a particular client based on a benchmark chosen by that client, such as the S&P 500.

SEC charged that after the Risk Model update in 2007, two programmers goofed. They were assigned the task of writing code that would link the new version of that program with the Optimizer. Their coding reported some information to the Optimizer in a decimal form, though other information was expressed as percentages. As a consequence, the Risk Model was working at a less than optimal level from April 2007 onward.

There was no independent quality control of their work. Matters seem to have rolled along in their sub-optimal way until June 2009, when another version of the Risk Model was to be introduced. A new Barr employee “noticed certain unexpected results” when comparing the 2009 model then under preparation to the older 2007 model.

He presented his findings to a Senior Official of Barr later that month and advocated that the error be fixed immediately. But the Senior Official said that it would be fixed with the new model was implemented, that September, and in the meantime told other Barr employees to keep quiet about the discovery, and in particular not to inform ARG’s Global Chief Investment Officer.

It wasn’t until late November 2009 that a Barr employee informed ARG’s Global CEO that there ever had been such an error. Thereafter, that company conducted an internal investigation and disclosed the situation to the SEC examination staff. In April 2010 it took the next step, informing its clients.

None of these entities (ARG, ARIM, and Barr) have admitted or denied any wrongdoing. Together, though, they consented to the entry of an SEC order that assigned joint and several liabilities of $25 million and that separately demanded that they pay $217 million to the clients of ARIM and other advisers affiliated with ARG to redress harm from the coding error.

Does this remind you of the ratings agency CPDO snafu? It is striking that time and time again folks make the assumption that models are somehow internal and proprietary and that if an error is made in one then no one need be told. The SEC’s actions hopefully act as reminder that a fiduciary duty can extend to not providing clients with misleading numbers, and that if your financials depend on model calculations, then you probably have to tell someone if those are materially wrong. JPM’s $3B of model risk reserves make a lot of sense in this context.

The strange death and patchy resurrection of professional integrity? June 22, 2011 at 10:32 am

I work with lawyers and accountants on pretty much a daily basis. Many of them are good people; many of them have impeccable professional standards. So I don’t entirely buy the line that Mark Everson plays in the New York Times that lawyers and accountants have lost their integrity. But I do think that there is something to his argument, so let me give you the gist:

Three or four decades ago, investors and regulators could rely on these professionals to provide a check on corporate risk-taking. But over time, attorneys and auditors came to see their practices not as independent firms that strengthen the integrity of capitalism, but as businesses measured chiefly by the earnings of their partners…

Obviously, to pay employees more and to increase partner pay to its present, staggering levels, billings needed to grow. Perhaps today’s approach to fee generation by leading law firms was best stated in a recent Wall Street Journal article about partners billing over $1,000 per hour. Said one such lawyer, “The underlying principle is if you can get it, get it.” Imagine a doctor saying that, for attribution, about an organ transplant.

Understandably, corporate clients are reluctant to pay through the nose for advice on how to color safely within the lines. Whereas concern for a company’s reputation on the part of its executives historically served to reinforce the conservative influence of the outside professionals, it is well documented that attitudes have shifted within corporations themselves. One need look no further than General Electric’s no-longer-obscure tax department to see how traditional law and accounting functions have morphed into profit centers.

Lawyers and accountants who were once the proud pillars of our financial system have become the happy architects of its circumvention.

Everson quotes a particularly well chosen example next:

Nowhere is this more the case than in the world of tax law. Companies (and wealthy individuals) pay handsomely for tax professionals not just to find the lines, but to push them ever outward. During my tenure at the Internal Revenue Service, the low point came when we discovered that a senior tax partner at KPMG (one of the Big Four, which by virtue of their prominence set standards for the others) had advocated — in writing — to leaders of the company’s tax practice that KPMG make a “business/strategic decision” to ignore a particular set of I.R.S. disclosure rules.

Certainly tax is one area where the spirit of the rules matters not a jot, and a lot of money is spent on trying to comply with the letter while not paying a dime more than necessary. That this is reputationally acceptable is a cause of sadness to me, but tears do not change policy. The IRS and other tax authorities can however fix the situation: they need to go nuclear on both the tax code which permits such manipulations and on optimization transactions like the infamous google double irish.

In the broad, though, the criticism is not completely fair. Audit partners are not typically for sale, Enron notwithstanding. If you want an honest opinion about an accounting standards issue, then you can get one from the larger firms. You can also buy advice about how it might be possible to structure things to get a desired accounting result, of course, and examples like Repo 105 do not do the industry credit here.

I am not sure that law firm conduct has changed that much. The term general counsel has the same root as Consigliere for a reason; a lawyer is there to help you do what you want to do legally, and to advise you not to do something stupid. A good lawyer is a reputational risk manager, amongst other things. But they are not there to outsource the CEO’s conscience, and I don’t think they have ever been. Advisors advise: it is the big guy who decides whether to take that advice or not, and hence bears responsibility for the decision. If professional integrity has declined, blame the CEO.

Operational risk in manufacturing March 16, 2011 at 4:10 pm

Basel 2 contains a substantial set of rules that require banks to monitor and capitalise operational risk. We screamed like scalded cats at the time, and I still think that the capital requirements are foolish, but one of the big advantages of making banks capitalise something is that they do actually start to monitor and manage it better. Thus banks are required to think about actual and potential vulnerabilities in their processes and systems.

Corporates typically do a much worse job of this, as the FT points out (HT Naked Capitalism):

Supply chains in many key manufacturing spheres increasingly hop across multiple borders. Last year, for example, the Asian Development Bank set about trying to assess how just one item, the iPhone, was made. This revealed a dazzlingly complex pattern, typical of numerous sectors. “Manufacturing iPhones involves nine companies, which are located in . . . the Republic of Korea, Japan, Taipei, China, Germany, and the US,” the ADB observed, adding that “the major producers and suppliers include Toshiba, Samsung, Infineon, Broadcom, Numonyx, Murata and Cirrus Logic”.

Now, in theory that dizzy patchwork of names and countries ought to imply that companies have plenty of choice about where to make things. In practice, however, competitive cost-cutting has forced companies to streamline their operations to such a degree that if something goes wrong with one step in their complex, cross-border supply chain, the entire system can break down.

In other words, complex supply chains might be cheaper, but they are also riskier. If you charge the capital needed to support that operational risk at a reasonable rate, then the cheap solution suddenly looks a lot worse. The practice of looking at risk adjusted returns outside of finance is in its infancy; it could be a powerful tool if its use grows.

Update. The famous example of over-vulnerable supply chains, of course, is Boeing. See here for a good analysis of how badly wrong the 787 project went thanks to tolerance of excessive operational risk in the supply chain. My personal favourite from the troubled history of this project is: ‘December 2007. Boeing CEO Scott Carson says there will be no further delays in the 787 program. Then in April, a 3-month delay is announced.’ Reputational risk is always close on the heels of this kind of operational risk.

Empty creditors, the teamsters, and CDS February 3, 2010 at 7:58 am

In general I am a staunch defender of credit derivatives: they make the credit markets much more efficient; they help to companies honest by letting traders short a credit; and the ability to hedge credit lets banks lend more. However, it has to be said that creditor’s rights can be a problem with credit derivatives. Specifically if I own a bond (or make a loan) and have credit protection on that exposure, I may have the right to vote in creditor’s proceedings, such as restructurings, but I may have a different incentive to vote, or no incentive at all, thanks to the credit protection. This situation is sometimes called an `empty creditor’.

A particular problem is that an investor can sometimes buy bonds for less than par, buy CDS on those bonds, then get paid par if there is a credit event. They are incentivised to vote the bonds in such a way as to maximise the likelihood of that credit event, not to ensure that the company survives (or even that the bonds have the highest ultimate payout).

Now an interesting riff on the problem of empty creditors has come up. Risk.net reports that:

Goldman Sachs stopped making markets in bonds and credit default swaps on US freight company YRC Trucking for around two weeks from December 16… The decision to stop quoting on YRC is understood to have been taken at a very senior level in Goldman, after freight union International Brotherhood of Teamsters (IBT) sent letters to congressmen, senators and state attorneys-general accusing the bank of encouraging investors to torpedo YRC’s restructuring – which would have threatened the jobs of around 30,000 IBT members.

Goldman quickly threw its weight behind efforts to help the company stay on its feet, sourcing additional bonds for investors that wanted to vote in favour of the restructuring, which subsequently went through successfully… the union obtained screenshots of a Bloomberg run sent by a Goldman trader on December 16, quoting prices on three YRC bonds and – on the same screen – CDSs in the trucking company. This was, they argued, proof the bank was encouraging empty creditors to build basis packages in YRC with the aim of killing the company.

Kudos to the teamsters: that was smart. Taking out an investment bank at the crucial time worked well, and Goldman was the obvious choice given their elevated reputational risk at the moment. There is a lesson here for subsequent distressed restructurings.

Who is liable if neither of you understand the trade? January 26, 2010 at 8:59 am

Broken

At Jack on tap we find:

Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principle… Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties (if this wasn’t true, we wouldn’t need lawyers). Certainly, if a supplier sold GM a faulty $1 part used in a Chevrolet, we wouldn’t want to shield the supplier from liability simply because there are automotive “professionals” that also work at GM. It eludes me as to why you’re liable if a $15 toaster blows up, but not if a $1 billion collateralized debt obligations of asset-back securities does.

(Hat tip FT alphaville.)

This all seems reasonable (and comes with the usual I-am-not-a-lawyer-indeed-I-don’t-even-know-how-to-cook-one disclaimer). And undoubtedly there are many instances of devious, scheming bankers selling products they knew (or strongly suspected) were toxic to naive investors, including naive professional investors. The industry short hand in some quarters used to be `Belgian pension fund’, meaning any sleepy, ill-informed party who had the authority to enter into transactions they could not price and might well not have understood the risks of. If some people had something they really couldn’t sell to the cognoscenti, they found a Belgian pension fund.

CDOs of ABS, however, are a slightly different story, at least in some cases. These were products that neither buyer nor seller understood. In many cases both parties used the same flawed model to analyse the product; both parties failed to dig deeply into the underlying collateral; both parties did not think through the consequences of the forms of credit enhancement present*. It suits the current mood to blame the industry – or just Goldman Sachs if you prefer – for knowingly blowing investors up. But the truth is rather more complex. I doubt that this will ever come out. The `we didn’t understand it either’ defence might work against a claim of fraud or misrepresentation, but it does rather open the door to a case of failure of due diligence…

* A good example is the use of excess spread accounts. These work as credit enhancement providing defaults happen late enough in the life of the structure. If they happen early, however, as in most of the 2006 and 2007 vintage CDOs of ABS, they are useless.

Paradigm hunting December 3, 2009 at 3:12 pm

Like most things which create careers and make money, science isn’t what it claims to be.

It claims to be objective; validated by experiment; unbiased. Of course it isn’t because that takes far too much time. Usually the cranks are exactly that. So it would be an awful waste to test their claims or otherwise take them seriously. Similarly the promotions are in the hot topics, the topics that are getting published in the big journals. Stick with those, stick with the orthodoxy, and you have a career. This is entirely rational: paradigm changing science comes along infrequently, and it is a very good working assumption that any given anomalous result is a screw up rather than a harbinger of a dramatic new theory. Moreover, scientists are people: they have rivalries, jealousies, and such like too.

Scientists, then, for entirely practical and understandable reasons, don’t do science very objectively. And mostly that does not matter. A really good idea will win out eventually, albeit possibly after its creator has died. Some middling good ideas never make it, but the loss is not huge given the increase in efficiency that seeming-crank-avoidance brings. It’s OK, really, most of the time.

(Much of the landscape here has been surveyed by sociologists of science, such as Pierre Bourdieu. Donald MacKenzie has a nice take in the LRB here.)

Unfortunately, as Daniel Henninger points out in the WSJ, when politics enters the picture, things become rather less OK. I don’t agree with much of the Henninger article. However, his basic point – that the failure of scientists at the East Anglia Climate Research Unit to act the way scientists are supposed to act has caused great damage to the image of science – is sound. And it is a great pity.

First, it is worth saying that most people’s emails, if widely published, would cause some embarrassment. It is no surprise that things are no different for scientists.

Second, as we have seen in several cases recently, politics asks too much from science. Or at least politicians do. The real answer to many, perhaps most scientific questions is we don’t know. Experts give advice based on best guesses. This is particularly the case with climate models: like models in many other areas, they are approximations. We think that they work. There is good evidence that the work in some domains. But we are using them well beyond the area that we are really comfortable with. That means that there is model risk. So yes, climate change might not be as bad as our best guess – and it might be worse. It might happen sooner or later than we think. The balance of risk versus cost strongly suggests doing something now, and something pretty drastic. But we can no more know for sure that this is the right thing to do than we can know for sure that the sun won’t explode tomorrow.

What we need desperately is more evidence based politics. This requires three things:

  • Carefully gathering evidence, and using the best available theory to analyse it;
  • Forming policy on the basis of that analysis;
  • Ongoing review, including changing your mind if the evidence and/or the theory changes.

Politicians find that last part particularly hard as it can involve loss of face. But what would you rather have, someone trying to do the right thing, while acknowledging that they might be wrong about what that thing is, or someone who has blind faith in their decisions whatever the evidence?

Bankers shot on the BBC: spooky November 19, 2009 at 8:34 am

It is an interesting sign of the times when the BBC feels that it is OK to show a banker being shot by an anti capitalist in a prime time show. Now this is fiction, of course, but I can’t help but think that this story line would not have been considered two years ago. The public mood has changed: banker beware.

Update. Joe Biden says bankers are less popular than rattlesnakes. Hardly controversial, I fear.

Goldman Sachs Is Too Big to Tell It Straight? October 22, 2009 at 10:48 am

Goldmanosaur?Jonathan Weil has an suitably skeptical take on Goldman’s latest media posturing in Bloomberg here. This article is of course just another in a string of negative stories. Goldman’s previously impeccable media profile has clearly taken a turn for the worse. Matt Taibbi might have kicked off matters in Rolling Stone, but many others have followed since. The interesting question is why now? After all, Goldie has never been universally loved – no bank, investment or otherwise, has been. But since Goldman came out of the crunch far ahead of the pack, it has attracted a lot more criticism. Is this just a belated realisation from the media that it is OK to criticise banks, especially profitable ones, or is there an element of tall poppy syndrome?