The financial crisis has been created by a number multiple situations unfortunately converging in the wrong space at the wrong time. It will take years for the analysis to be concluded and the financial disaster diagnosed and eventually remedies realised and put into practice. What is very clear immediately is the ability of financial institutions to manage risk, is not as good as we all thought.

 

Most risks are measured against a historical benchmark. Similar past situations in the markets are used as models to test against the immediate problem. The results of these tests can bring comfort to the financial institutions as well as indicate what solutions might be used to recover. However, what happens when there is no historical basis to measure risk against?

 

The modern markets have evolved quickly over the last twenty years with new dependencies and market structure unlike anything from the past. The differences are huge but a short list would include globalisation, communication, speed, complexity of financial instruments and a culture within the financial institutions of self greed.

 

Globalisation has been a continuous process since the mid eighties as deregulation encouraged many global banks to buy into international markets. This has caused an increase in systemic risk throughout the largest domestic markets where once countries and their governments could contain global impacts with domestic policy. Nowadays governments are virtually powerless to effectively influence global financial matters simply by taking action within their own markets. Without any protective barriers countries are exposed to the volatility of global financial markets where massive financial institutions can manipulate conditions towards their own ends.

 

The massive improvements in communication are the super highway, spreading both good and bad news and increasing the risk of trading and investment. There is very little latency within the world’s financial systems where time is not available for players in the market to understand and analyse what’s happening as share prices move both up and down, bringing huge volatility into the markets. The result is a herd effect, where traders are in a maelstrom, high powered game, of keeping up with the Joneses. Rumours have always been a factor in markets but the ease to which it is now possible to seed these, utilising communication channels has opened up new risks. Of course the regulators try and monitor this flagrant breach of rules but in reality it’s almost impossible to prevent and equally impossible to detect and prosecute.

 

Speed they say is of the essence but in today’s markets speed is a new great risk factor. The ability to process millions of trades in milliseconds increases the probability of errors in trading. The chances of mispricing have increased despite fail safe functionality supposed to prevent these instances. Speed in the trading room can create a higher risk in the back office. The credit checks and trade confirmations are a fundamental part of operating efficient markets. Today however, there are many instances on a daily basis of executions running ahead of the credit checks and bypassing important controls and all in the name of speed. When markets become confused and fear begins to take a hold, speed becomes the friend of risk.

 

Since the creation of Futures and then Options, the market has to come to terms with no end of new types of derivative and new strategies. The ability to sell short and overcome risks by linking the short to any number of other products apparently covering the risk has been proved to be erroneous thinking. The cross asset elements of derivative trading strategies are encumbered by the silo natures of managing assets. Often the overall risks will be camouflaged by the historical structures supporting different financial products. In deed the management structures and systems within financial institutions normally support the silo. There is a big job protection ethos within the market maintaining this operation.

 

So accurately identifying the real risks in complex financial products can be extremely difficult and even in the most prestigious banks will necessitate the use of manual compilation of data from multiple sources in spreadsheets. This is supposing the banks actually understand what data needs to be collected and where it resides. Which brings me onto the ability of senior banking people to understand and authorise the trading?  Years ago Barings showed how senior management breakdown can build a haven for the over adventurous trader. The Nick Leeson factor is still prevalent today! Despite attempts by regulators we still see instances of the rogue trader. This has to stop!

 

Senior bankers must be called to prove they understand the financial products they authorise their traders to carry out. The supposed profitability of the business must not mask the need for banks to employ board directors that have a personal responsibility to authorise the use of complex products. Banks should gain regulatory approval that protective procedures systems are in place and that adequate risk management is available, which is supported by detailed knowledge at board level. Nothing less is needed!

 

In the past financial institutions always rewarded success of the business and the individuals that contributed. So we have always had stars earning very good money and incentivised to do better. The problem today is the breakdown of the unwritten moral obligation between employer and employee. When employers sack people because the market has not been good and profits are down, they can not expect loyalty from their staff if better offers come along. No one stays too long anywhere nowadays. Without loyalty to the firm the star trader/salesman are like gun slingers hiring their ability to the highest bidder. Individual status is a big thing in the financial markets. Status builds egos and creates an environment where self development is uppermost, rather than the good of the firm. Such a business environment is dangerous and encourages riskier deals. After all it’s someone else’s money.

 

In the past there was certainly a greater level of loyalty built from security of position and a desire for the firm to succeed. Incentives and high rewards are an essential aspect of the finance industry but they must be kept in balance with the needs of the firm and the market in general. Firms should only be paying bonuses from realised profits rather than based on paper.

 

We have seen that the only true value of the banks is on the real cash in hand. The power of the bank is to manage the risk reward for their clients but also to themselves. It is traditional banking that is proving the winner in today’s market. Lloyds TSB has proved that the traditional tested methods of banking wins in the end. The application of many of the banks has to be questioned and when the recovery begins a more sober and conservative approach will help build confidence in the financial markets.

 

A new appreciation of the risks that a financial institution undertakes needs to be understood and a new benchmark established far lower than before the crisis. With a return to a more pragmatic style of banking, this should include a higher ethical business environment that encourages development and rewards success with a sensible payment structure. The ability to innovate new financial products should always be encouraged but they should be only implemented once fully understood by all concerned especially at board level. Personnel accountability is fundamental to the producing a resilient and responsible management culture.

 

Most importantly the risks within financial services and its products need to be revaluated. The management of risks has to be centralised with cross asset trading moving away from silos into horizontal operations where the client account provides the complete universe of activity and where pricing and exposure provide a clear picture for management, anything less will make risk just a four letter word.     

 

By Gary Wright