This is going to end in tears

I read in today’s FT that “the World Bank is encouraging developing countries to buy insurance in the derivatives markets against sudden changes in food prices” and that they’ve established a facility (credit line) to allow the whole thing to take place. “The facility will target the private sectors of developing nations, including farming cooperatives and food processing companies.” Through a deal with the World Bank, “JPM [JPMorgan] would offer simple hedging instruments” the article says.

Mr. Zoellick, World Bank president is quoted as saying that “food prices were the single gravest threat facing developing countries”.

I’ve never yet seen a simple hedging instrument that can take that threat away. I’ve rarely seen an investment bank that can sell just a simple hedging instrument.

And if one thinks that the locals get restless when food prices go up, wait and see what happens when food prices go down but the price is still “hedged”.

What’s this? Oh, on the front page of the same paper, there a snippet that says “JPMorgan will pay $153.6m to settle allegations that it misled investors in a complex mortgage-backed derivative by not telling them a hedge fund betting against the transaction had helped select the underlying securities.”

Watch this space.

Plus ca change, plus c’est la meme chose

Just reading about Honda’s (yes, THAT Honda) little foray into trading shrimp and shellfish, and the inevitable loss from “inappropriate transactions”. US$180 million. Ouch!

Some people never learn. There is a catchphrase that came out of the Barings disaster in 1995 that says of trading, “the size of losses increases with the distance from head-office”. Oh, and one of the other catchphrases was “understand your profits, and you’ll understand your losses”. So, according to the article in today’s FT, the losses were incurred by “staff in an obscure corner of its business that trades in shrimp and shellfish”. The business unit, known as Honda Trading, was to “source components for Honda’s carmaking business from international and domestic suppliers…” Well, that makes sense. But you should know, some traders can never sit idle, hell that’s what traders are for, to trade. And if what they’re trading today isn’t giving them enough excitement, then they’ll try to get into something new. I don’t have to  imagine the board presentation that supported getting into shrimp and shellfish, because I’ve seen plenty like it before. Traders usually rely on the “if you don’t let me do it, I’ll leave” argument. Let ‘em go, and save yourself money. My advice is always the same – if you want to punt on something outside your normal line of business, put $20 million in the bank, start punting, and when that’s gone, think again. And then explain it to the shareholders.

 

 

Asia has a lot to learn, apparently

Just turned up an article by Ernest Kepper written for the Asian Wall Street Journal on 18th February 2004. The article laments the lack of a risk management culture in Asia and says:

“There has been a revolution in the American approach to risk management. The military perfected it and the government has adopted it. Risk management has also permeated US business and all large corporations have a senior vice president in charge of risk management plus a senior risk officer. There has been a sea change, from managing individual risks to adopting a company-wide approach to involving all levels and marrying line management with risk management.”

The article continued:

“Even senior officials in some Asian central banks do not always fully understand what dealing with credit or operational risk is all about.”

Aren’t we lucky that “western” central bankers did understand credit and operational risk? Hell, otherwise we’d be in the middle of a Global Financial Crisis with banks dropping and countries defaulting. Wait a minute! We are.

What with Ireland in trouble, and all manner of other uncertainties,  I think the poem below should be standard reading for any risk manager:

The thoughts of others

Were light and fleeting

Of lovers meeting

Or luck or fame

Mine were of trouble

And mine were steady

So I was ready

When trouble came

(A.E Housman)

 

Risk management starts at the top

John Morschel, Chairman of ANZ Banking Group was recently quoted:

“The biggest single risk is not operational risk management but new software being put into existing systems”

If you’re a Chief Risk Offier, you don’t get a clearer message than that as to what your priority should be!

 

Thank you, Timothy Geithner

The headline quote on the front of today’s Financial Times by US Treasury Secretary Timothy Geithner leads nicely into the next discussion on what makes a robust policy document.

He is quoted as saying in relation to the value of the yuan:  “Wishing something does not make it so, and issuing a report that requires me to go and consult changes nothing”.

Precisely.

When reviewing risk management policies for corporations, I frequently come across documents that should more correctly be called “wish lists” than policies. The objectives of the policy are very clearly stated but there is no specific action, other than “best endeavours” to achieve the objective. That makes for a very weak policy indeed. Usually the weakest area is in the achievement of a company’s policy on work-life balance. There will be grandiose words on the merits of work-life balance and strong language about the need for people to take control of their lives, and all staff will have the full support of the company etc.  And there it ends.

Rarely does a “policy” on work-life balance include any definable action steps that can actually ensure that the objective can be achieved.  One that I have seen (and you may question its effectiveness but at least it is a positive action step), was implemented by a company in Manila. To get people to go home at a reasonable hour for Manila, they turned off all the lights at the master switch at 9:00pm. Did it ensure work-life balance? Well, a hell of lot more than simply “wishing” that people would go home.

I’d encourage every risk manager to conduct this simple test on the company’s policies – write down the objective of the risk policy and then see if there are any definable steps that actually ENSURE the objective will be achieved. If not, the policy’ s a dud. A wish list, an admirable goal maybe, but certainly not a policy.

Setting objectives – you can’t have your cake and eat it

If we assume that you’ve properly done your homework to understand what your risks are, the next question is – what do you want to do about it?

It’s entirely acceptable for you to ignore it of course. That’s your choice, or at least it’s usually your choice. If you’ve let the bankers stitch you up with covenants, well, maybe it won’t be your choice and you’ll have to do whatever you need to do to stay within the bank’s good books.

I remember a company in the 80s that had significant offshore operations and the value of those operations was not surprisingly, subject to exchange rate risk when translated back to the holding company’s own currency. Nothing unusual about that, but the company carried a covenant from its lenders that its debt not exceed a defined percentage of its balance sheet.  Volatile exchange rates could play havoc with the valuation of that balance sheet so the company had no choice but to hedge its overseas assets, often at a very high interest cost. So, a policy that had as its objective “minimize the cost of hedging” (as many policies do) would be pointless, as the decision as to whether or what to hedge was taken out of the company’s hands. The overriding objective was “don’t breach the covenants”.

Many policies that I have reviewed contain objectives that are vague, ambiguous, unattainable, or even in conflict with other objectives within the same policy. The test of a good policy is that the objective must be able to be “recited” by anyone who has an interest in it, whether that’s the Chairman reporting to shareholders, the dealer implementing the policy and risk management strategies, or the auditors conducting their review. The members of the Risk Committee should be in no doubt as to what the clear and unambiguous objective is.

Let’s face it though, CEOs are opportunists and are used to getting their own way with management, so when presented with a précis of the risks of the company and being asked to give guidance on what the company’s objectives should be, they’ll often say “I want this, I want that, and a bit of this too. I want maximum protection at minimum cost with total flexibility” The risk manager, the consultant, perhaps the member of the Risk Committee needs to be able to say to the CEO “I’m sorry, you can have A, but you can’t have B too (as they may be inherently in conflict) so you need to choose which one will drive the company’s policy”. Many CEOs don’t like being boxed into a corner like that of course, but trust me, they’ll respect you for developing a better policy.

I recall the CEO of a large mining company becoming increasingly frustrated at the attempts by management to define what the risk management objectives should be for their commodity risk. Eventually the CEO rose from his chair, and expounded “Look, I’d rather stand up in front of the shareholders and tell them why earnings were down because commodity prices fell, than to have to tell them they missed out on gains because we were hedged.” Bingo! – There’s your policy. The CEO understood that shareholders bought in to the company as a speculative play on commodity prices and the last thing the shareholders wanted was to be locked out of any speculative gains. So any other objectives that might sound comfortable and safe, were irrelevant, or at least overridden by that one very clear objective – make sure that the shareholders participate in commodity price gains.

The goal (and skill) of anyone formulating and writing risk management policies is to get that level of clarity from their CEO.

Is risk management in some banks a farce?

It will be interesting to see how the banks react to the new financial regulations. If it’s anything like the time when Basle II was introduced, they’ll immediately put their best minds to work to figure out how they can work around them. That’s what happened when the rationale was for banks to hold a minimum amount of risk capital to ensure their health – the banks immediately put their rocket scientists to work to figure out how to redefine risk capital so that the bank put aside as little as possible. Go figure.

It’s a bit like being told by your doctor you need to get your cholesterol down and then figuring out how you can fool the test to get a good reading whilst still indulging in an unhealthy lifestyle.

If we go back about 30 years in Australia, the culture was that drink-driving was unacceptable and dangerous, but everybody did it. When new (and seemingly harsh) drink-driving laws came about with random breath testing as well, there were howls of protest about freedom of choice, the interruption to social life, and the stiff penalties. Governments went ahead anyway, with programmes that consisted of education, clear visibility in the random testing and actual implementation of the penalties. The result today is that people’s behaviour has changed – when the programmes were first introduced, it was acceptable to try and beat the system (for example, by driving the back streets) but now it is accepted by the majority that taking a taxi or remaining sober is necessary for your own and safety of others.

Of course, there are still those who try and beat the system. As I watched the lobbying to water down the regulations, I couldn’t help thinking that some banks and bankers, intoxicated on the spirit of greed and personal profit, still haven’t got the message. They’ll still continue to overindulge, then try and sneak around the back streets to avoid getting caught.

The lesson the regulators might take from the drink-driving campaign is clear – random test often and without warning, and most importantly, hit hard when banks transgress. That sure as hell hasn’t happened to date.