Ongoing management

15.3 CLUES, CAUSES AND CURES

15.3.5 Ongoing management

Weakness in the daily management of risk exposures, and in the personnel responsible for taking or overseeing risk, increases the chances that losses will occur.

r

_Clue:Large profits are not investigated.

r

_Causes:Top management rewards large producers without understanding how they make money or questioning how potentially large gains are related to risks. Management prefers to keep its “head buried in the sand” when times are good and merely show good results. In addition, the accounting function may not be strong enough to delve into the real source of P&L, and the P&L explain process may not be working adequately.

r

_Cure:Insist on a thorough explanation of any gains or losses above a predefined amount, every day. No manager should be satisfied until the nature and source of all large gains is well understood. Make sure that the infrastructure is robust enough to deliver the information regularly and on a timely basis, and that the financial control function is appropriately staffed.

Once profits and losses have been explained ensure that the results fit into the firm’s stated risk mandate and that executive management is comfortable with this. This is intended to solve the P&L explain, governance and accounting transparency issues highlighted in Chapters 9, 10, 12 and 14.

r

_Clue:Unusual cash movements, payments or obligations occur – but are not questioned.

r

_Causes:Risk takers may be funding obligations that are not known to others in management or control – that may be indicative of large risk exposures now, or in the future.

r

_Cure: All requests for funding must be analyzed and approved by those outside of the business function; businesses cannot be allowed to have a free call on the firm’s treasury without justification. Business managers should explain large or unexpected payments to risk and treasury managers before any payments are authorized (risk managers must ensure that these always relate to risk that fits into the risk mandate). This is intended to solve the funding issues highlighted in Chapter 3.

r

_Clue:Operational risk losses occur with frequency.

r

_Causes:Coordination between front- and back-office processes may be broken. Back-office and settlement personnel may be inexperienced and might be given too much authority for their relative level of market knowledge. New account, securities transfer and/or collateral procedures might be unclear (or non-existent). Additionally, technical infrastructure sup- porting business activities may not be able to cope with high volumes or might require too much manual intervention.

r

_Cure:Ensure a smooth and efficient link between front- and back-office processes. If needed, institute a “middle-office” group to make sure nothing can fall between the cracks. Staff the operational function properly, and ensure that the ability to transmit cash/securities/payments is done at a proper level of seniority and experience. Make sure that all operational poli- cies related to new accounts, wire transfers, collateral management, etc. are in place and being followed. Determine where weak links in the technology infrastructure supporting operational processes exist (e.g. lack of scalability) and implement alternate technical or manual solutions – with proper audit controls. This is intended to solve the process risk issues highlighted in Chapter 5.

r

_Clue:Exceptions to the framework are permitted with frequency and/or are carried for a long time.

r

_Causes:Business managers and risk takers have figured out that the risk function is a “paper tiger” that will approve continuous extensions to the risk profile. In addition, executive management may not take an active interest in the exception process, or are willing to support risk requests blindly.

r

_Cure:Enforce the risk framework process by only allowing a certain number of exceptions at any time, and by limiting the length of those exceptions to defined time horizons – without any possibility of extension! Ensure that senior management is regularly informed of the worst-case scenario of every exposure contained within framework limits as well as those granted on an exceptional basis. This is intended to solve the framework and limit exception issues highlighted in Chapters 11 and 12.

r

_Clue:Illiquid, complex, leveraged, aged or concentrated positions are permitted to grow without constraint.

r

_Causes:Business and control managers do not fully appreciate, or are ignoring, the damage such exposures can create, the technical infrastructure cannot track or aggregate positions, the risk limit structure is too liberal, positions are deliberately or mistakenly misvalued.

r

_Cure:Implement a risk framework process to control exposures, concentrations, aged in- ventory, and so forth. Ensure that this fits into board and CEO-approved risk tolerance and that there is awareness and discussion about the worst-case scenario for these positions.

Fix the technology platform as a matter of priority (particularly if risk aggregations are in- volved). Upgrade or reinforce the independent financial control function, insist on periodic liquidations of positions to prove marks. Make sure that policies, new product/commitment and client suitability committees are being used appropriately. This is intended to solve the framework, governance and liquidity issues highlighted in Chapters 3, 9 and 11.

r

_Clue:Business managers permit aggressive risk-taking behavior to proceed without check.

r

_Causes:Prudent management of risk is not a corporate imperative, senior managers are not in control of their risk takers (and do not understand their capabilities and personalities) or they fail to appreciate that aggressive behavior can lead to financial losses.

r

_Cure:Put stronger business managers in charge of “aggressive” risk takers or reassign those that are overly aggressive to areas where they can add value but not commit capital. This is intended to solve the personnel management issues highlighted in Chapter 13.

r

_Clue:Accounting and financial policies lack transparency.

r

_Causes:The accounting department may not be qualified to understand the complexities of the business or may be understaffed; risk takers and business leaders may intimidate junior accountants. Reserve and mark adjustments may leave too much leeway lower down in the organization. Additionally, the accounting team may lack the independence and integrity needed to question the businesses.

r

_Cure: Put strong and experienced financial controllers in key accounting positions, and support their efforts. Insist on clear, documented financial and accounting policies for key areas such as reserves, valuations and markdowns; make sure that reserve/valuation decisions are made at an appropriate level and receive proper visibility. Occasionally mandate the sale of part of large concentrated positions to verify prevailing marks. This is intended to solve the financial transparency and personnel skill issues highlighted in Chapters 9, 10 and 12.

r

_Clue: Legal documentation backlogs are significant, and permitted to increase without constraint.

r

_Causes:Managers do not understand the financial damage legal and process risk can cre- ate. The legal department may be understaffed or inexperienced, and/or technical resources supporting legal and operational processes may be insufficient to track the status of docu- mentation.

r

_Cure:Constrain business activities when documentary backlogs exist and ensure awareness of documentary status at all times. Staff the legal and operational functions appropriately.

This is intended to solve the process and legal risk issues highlighted in Chapters 4 and 5.

r

_Clue: Clients routinely enter into highly leveraged transactions or complain about the risks they are being given or the losses they are sustaining on transactions.

r

_Causes:The firm is operating without proper sensitivity to client requirements, and is un- aware of, or unconcerned about, how clients fare in transactions. Business management may be following acaveat emptorpolicy in its dealings, interested only in trying to make as much money as possible for the firm (or themselves!). A formal client suitability review process probably does not exist.

r

_Cure:Establish a client suitability review forum with proper representatives from the busi- ness, risk management, legal and financial control functions. Create minimum standards for

disclosure and downside exposure. Make sure client strategy edicts are driven from the very top of the firm! This is intended to solve the suitability issues highlighted in Chapter 4.

r

_Clue:Confusion exists about reporting lines and management structure; communication breakdowns occur with frequency.

r

_Causes:The firm operates a complex geographic/product/client/legal entity split that lacks clarity and fails to assign ultimate responsibility. Individual managers may be trying to

“grab P&L” by taking over product or market responsibility that is not rightly theirs, thereby creating confusion. Internal politics and time-zone differences may be complicating the situation.

r

_Cure:Minimize matrix reporting relationships. When these cannot be avoided, be “crystal clear” in assigning management responsibilities for products and clients. Internal rules for trading, risk control and financial accounting have to be very simple in order to avoid confusion about accountability; clearly document all such roles and responsibilities. This is intended to solve the manual management issues highlighted in Chapter 13.