1. What is the business of the company and how do they make their money?
2. What are the top 10 “balance sheet” risks of the company?
3. Do you feel comfortable that the results accurately reflect economic performance?
4. Do you feel comfortable with the risk versus liquidity profile of the company?
5. Are you comfortable that you receive sufficient and accurate risk information to fulfill your role?
6. Do you feel that the “balance sheet” risk disclosures are clear, accurate and transparent to shareholders and creditors?
7. Are you comfortable with the company’s ability to withstand an isolated or general dislo- cation in the market place?
8. Are you comfortable that the company has uniform accounting and risk standards through- out the organization capturing, in particular, all subsidiaries, collateral and special purpose vehicles?
9. Has the company entered into transactions that would substantially alter its balance sheet in the future? If so how?
10. Do you feel that the risk process in place and quality of personnel are up to the complex task of keeping the company away from unpleasant financial risk-related surprises?
The hope at the end of the day is that through a greater focus on ongoing diagnostics and improved transparency, the shareholder is able to discern the 10 aspects of “balance sheet” risk that most affect an investment. This is certainly not possible today, but we believe that it can become possible – with some work and commitment!
Conclusion: Can there be Heroes?
Which CEO and board will be the next to trip up? Which regulator or auditor will be “guilty by association”?
Snowboarding the Himalayas is dangerous without a guide. But few guides have the experi- ence required, and none are perfect. Common sense must therefore prevail, and the more you actually know about the mountains and snow conditions, the better your chances of survival.
Translated into financial lingo, we believe the next victims of unwelcome financial avalanches will be the CEO, board, supervisory regulators and auditors who:
1. Allow business to be conducted without risk controls;
2. Permit the existence of weak risk controls; and or 3. Fail to make decisions based on common sense.
Throughout this book we have built a case for strong “balance sheet” risk control. We have explained some of the risks and measurement tools at our collective disposal. We have also proposed a framework for effective control. It is not perfect, and is certainly not the only one that can be built. What should be clear, however, is that operating without some formal risk control process, or implementing a faulty one, is unacceptable. Regardless of the specific risk process in place, you should always remember that we have presented a methodology, not a universal remedy for everyone. Each organization is different and adequate allowance must be made for this fact.
As we have discussed earlier, any risk discipline, however good, is a necessary, but by no means sufficient, precondition to good risk management. To be effective the risk process must be accompanied by strong decision making based on complete, unfettered and thorough information – together with a healthy dose of common sense.
Human beings have a herd instinct that is reinforced by capitalism. Organizations tend to hire people who are similar in nature and who are often concerned with behaving like their colleagues or competitors. A few years ago, herds of bankers were falling over each other to lend to, or raise capital for, telecommunications companies. At the time these were perceived as attractive investment opportunities. It took courage not to join in these festivities by pointing out that many of these companies were overvalued “works in progress” with no predictable cash flows. Those who did, and were right, suffered the wounds of the slings and arrows from investors, analysts, competitors, clients and colleagues. These people have all long been
forgotten. Effective risk management must therefore take account of the sociological reality that decisions are often made by people more concerned with perception than shareholder interests.
It, therefore, ultimately falls on the shoulders of CEOs, board members, regulators and auditors to understand, and accept, that the buck stops with them. There are heroes onlyafter the damage has been done. Given this unfortunate reality, risk decisions must be driven from the highest echelons of the command structure, where common sense and a healthy dose of skepticism will also prevail.
Safe snowboarding!
Glossary
We have tried to keep technical jargon to an absolute minimum in this book, but have had to fall back on certain “commonly used” financial terms in a few chapters; this section features simple definitions of these terms.
10K the term for the annual report filing all US-registered public companies must file with the Securities and Exchange Commission.
10Q the term for the quarterly report filing all US-registered public companies must file with the Securities and Exchange Commission.
Aged assets assets held for sale that have been carried on the books for a long period of time;
aging may be indicative of misvaluations.
Analytic measures methods of measuring the riskiness of positions that can be com- puted through relatively straightforward mathematical formulas (e.g. duration, or bond price sensitivity).
Arbitrage financial dealing, investing or structuring intended to take advantage of market discrepancies in order to generate risk-free (or low-risk) profits.
Asset/funding liquidity risk the risk of loss arising from an inability to fund a position, leading to the forced sale of assets at less than expected. A subcategory of liquidity risk.
Asset liquidity risk the risk of loss arising from an inability to realize expected value on assets when needed. A subcategory of liquidity risk.
At-the-money option an option where the market price is precisely equal to the strike price.
Authorization risk the risk of loss that comes when an individual commits the firm to a transaction he or she is not authorized to approve. A subcategory of process risk.
Backtesting a process of reviewing past profit and loss performance to determine how it accords with results suggested by value-at-risk (or other risk) models.
Basis risk the risk of loss due to adverse changes between two similar reference assets.
Business recovery risk the risk of loss arising from a temporary disruption in business activities due to lack of accessibility to physical infrastructure. Not as damaging as disaster recovery risk, and generally firm-, business- or product-specific. A subcategory of process risk.
Call option a financial contract giving the purchaser the right, but not the obligation, to buy a specific asset at a predetermined strike price.
Capital commitment a financial transaction, such as an underwriting of securities or loans, where the lending institution uses its own capital to fund the transaction – with a view to subsequent distribution or syndication to other investors or lenders.
Chinese Wall the name given to the mandatory separation in financial institutions between functions that actively call on clients and arrange deals (e.g. bankers) and those that are privy to non-public information related to those clients (e.g. research).
Collateral assets (e.g. cash, securities, letters of credit, physical property) taken to secure, or protect, a credit exposure.
Collateral risk the risk of loss arising from errors in the nature, quantity, type or specific characteristics of collateral securing a transaction or from price risk related to the value of the collateral. A subcategory of process risk.
Committed funding financing from a bank that cannot be withdrawn, requiring a bank to fund its client regardless of the market environment or borrower’s financial condition. Funding facilities with a material adverse change clause or contingent trigger cannot be regarded as committed.
Concentration risk the risk of loss arising from a concentrated position – large position in a single asset or risk exposure.
Contingent credit risk the risk of loss arising from a potential credit exposure that could ap- pear in the future (e.g. drawdown on a bank line or commercial paper program). A subcategory of credit risk.
Contingent triggers financial covenants in a credit agreement requiring a borrower to undertake certain actions (e.g. lower debt, sell assets, issue equity) if predefined events occur (e.g. rating downgrade, breach of financial ratios).
Convertibility risk the risk of loss arising from an inability to convert local currency into hard currency (e.g. US$, euros, yen) and/or to repatriate hard currency back to a home country.
A subcategory of sovereign risk.
Correlated credit risk the risk of loss arising from credit exposure that increases precisely as a counterparty’s ability to pay declines, or when collateral taken as security deteriorates in tandem with a counterparty’s ability to pay.
Correlation the price relationships that exist between assets.
Correlation risk the risk of loss arising from a change in the historical relationships, or correlations, between assets. A subcategory of market risk.
Credit risk the risk of loss arising from non-performance by a counterparty on a contractual obligation. Credit risk can be subcategorized into direct credit risk, trading credit risk, correlated credit risk, contingent credit risk, settlement risk and sovereign risk. Also known as default risk.
Curve risk the risk of loss arising from changes in the shape of the maturity profile of interest rates, volatility or other asset classes.
Default risk see credit risk.
Delivery versus payment (DVP) a common settlement practice in the financial markets, where securities are delivered to the purchaser once payment has been received. If securities are released prior to payment, a settlement risk exposure is created.
Delta a measure of an asset’s price sensitivity to a small change in market prices; often used as an indicator of directional risk.
Derivative a financial contract, such as a swap, forward, future or option, which derives its value from an underlying reference asset or market (e.g. equity, interest rate, currency, commodity, credit).
Devaluation reduction in the value of a currency through market selling pressures of gov- ernment intervention.
Direct credit risk the risk of loss due to counterparty default on a direct obligation (such as a loan or deposit). Unlike trading credit risk, where the value of the contract may be in favor of the counterparty and thus generate no loss, a direct credit risk will always result in a loss for the lender. A subcategory of credit risk.
Directional risk the risk of loss arising from a movement in market prices.
Disaster recovery risk the risk of loss arising from a disruption in physical infrastruc- ture, which prohibits use of real estate, technology and communications; the disaster may be firm-specific, regional or system-wide. A subcategory of process risk.
Documentation follow-up risk the risk of loss coming from documentary requirements gov- erning specific financial transactions that have not been completed. A subcategory of process risk.
Double leverage borrowing at multiple levels within the company, e.g. at the holding com- pany and through a primary subsidiary.
Duration a measure of a bond or swap’s price to changes in interest rates. The greater the duration, the more sensitive the price.
Equity volatility the level of turbulence in the equity markets, often measured through implied volatility of options.
Fails to deliver financial transactions that are not settled properly, e.g. securities/monies are not received or sent according to instruction. Fails are commonly used as a measure of operations error risk.
Forward balance sheet a depiction of a firm’s balance sheet in the future based on its off-balance sheet activities, commitments and contingencies.
Front-office error risk the risk of loss due to trade ticket/input errors by front-office personnel. A subcategory of process risk.
Funding liquidity risk the risk of loss arising from an inability to rollover existing funding or to secure new funding to meet expected or unexpected payments. A subcategory of liquidity risk.
Gamma a measure of an asset’s delta sensitivity to a large change in market prices; as with delta, gamma is often used as an indicator of directional risk.
Generally Accepted Accounting Principles (GAAP) a body of accounting rules, adopted by many public companies, that is intended to provide uniform treatment of activities impacting the balance sheet, income statement and cash flows. GAAP is used in the US and various other countries.
Governance a formal process/structure, designed to protect shareholders, that ensures a company’s executives and directors are responsible for particular duties and that they are discharging their duties appropriately.
Haircut a discount taken on security held as collateral against an exposure; the haircut is typically a function of the price movement and liquidity of the security – i.e. the more volatile and/or less liquid the security, the greater the haircut.
Hedge an offsetting position taken in a financial instrument (e.g. security or derivative thereof ) intended to protect the underlying position. In a properly constructed hedge, a loss on one position should be offset by a gain on the other, for a net result of zero.
Implied volatility the volatility imputed from the market price of an option. See also volatility.
In-the-money option an option where the market price is above the strike price (call option) or below the strike price (put option), meaning the contract has immediate economic value if exercised.
International Accounting Standards (IAS) like GAAP, IAS are used to promote uniform treatment of financial dealings impacting the balance sheet, income statement and cash flows.
IAS rules are widely used outside of the US.
Inverse floaters securities with a coupon that is structured as the reverse of a normal coupon.
Thus, when interest rates rise, the inverse floating coupon declines, and vice versa. The reverse payment often adds leverage to the structure, making them far more sensitive to changes in rates.
Key-person risk the risk arising from the departure of one person, or a small team of people, critically responsible for a vital function within the firm (e.g. revenues, technology, operational support).
“Know your customer” rule a process where originators/bankers are made responsible for understanding a client and its financial needs (e.g. financial position, financial sophistication, risk appetite and profile, and so forth). The rule is designed to make sure that a financial institution conducts appropriate business with the right client base.
Legal risk the risk of loss arising from failures in the legal process, including lack of appropri- ate documentation (e.g. guarantees, netting agreements, bank agreements etc.) or enforceability in contracts, and so on.
Leverage the use of borrowings to magnify the potential returns, and risks, of a given investment strategy.
Leverage arbitrage an arbitrage scheme intended to take advantage of a misperception between a company’s credit rating and its actual financial activities/condition. This most often occurs when a highly rated company uses its credit rating to borrow, and then invest, very large amounts of funds in investments that will lead to an overstatement of the available rating of the company.
Linear instrument a financial instrument or transaction, such as a stock, forward or future, that provides a unit payoff for a unit move in the underlying asset.
Liquidation the process of selling assets or collateral in order to cover a payment or counterparty credit exposure. Collateral liquidation may occur when the counterparty is unable to post additional collateral on a transaction, or when it defaults on a transaction.
Liquidity risk the risk of loss due to an inability to sell an asset at carrying levels, fund a position or payment, or both.
Long position an owned, or purchased, position in an asset.
Marked-to-model the process of valuing a position based on mathematical models rather than market prices. This type of valuation occurs when the transaction is very unique (e.g.
long-dated, complex payout, etc.) and true market prices are unavailable.
Market risk the risk of loss due to an adverse move in the market value of an asset – a stock, bond, loan, foreign exchange or commodity – or a derivative contract linked to these assets. Market risk can be subcategorized into directional risk, curve risk, spread risk, basis risk, volatility risk and skew risk.
Material adverse change (MAC) clause a covenant in a loan facility or funding commitment that permits the lender to withdraw financing in the event of a severe market dislocation or difficulties with the borrower. MACs can make otherwise “committed” banking facilities disappear.
Maximum loss a measure indicating how much a firm might lose across a portfolio of risks by ignoring the “beneficial” effects of correlation.
Model risk the risk of loss arising from flaws in, or erroneous assumptions related to, math- ematical models or analytics used to value financial contracts.
Netting the process of condensing a portfolio of credit exposures with a counterparty into a single payment or receipt. In order to be effective, netting must be legally documented through an appropriate agreement, and recognized by the relevant legal system where dealing is taking place.
Non-linear instrument a financial transaction, such as an option, that features a payout that varies with changes in the market movement of the underlying asset. For example, while a small change in the underlying will lead to the same small change in the contract value, a large change in the underlying leads to an even larger change in the contract.
Off-balance sheet activities financial transactions that are not fully disclosed/carried on the balance sheet, including funding commitments, derivatives, special purpose vehicles and non-consolidated equity ownership.
Operational risk see process risk.
Operations error risk the risk of loss due to operational mistakes, such as late or misdirected payments or mishandling/misdirecting securities. A subcategory of process risk.
Option a financial contract giving the purchaser the right, but not the obligation to buy (call option) or sell (put option) a specific asset at a predetermined strike price.
Optionality see gamma, non-linear instrument.
Out-of-the-money option an option where the market price is below the strike price (call option) or above the strike price (put option), meaning the contract has no immediate economic value if exercised.
People risk the risk of loss arising from the departure of key individuals (or teams) that possess a great deal of knowledge and expertise related to the business, and who are not immediately replaceable. A subcategory of process risk.
Pin risk the risk of loss arising from a large option position (or many small ones) trading near the strike price at maturity. A small move above/below the strike price can dramatically change the hedging requirement and potentially induce large losses or gains.
Potential credit exposure a statistical methodology for computing the potential credit risk that might arise over the life of a dynamic (e.g. fluctuating) contract, such as a derivative or repurchase agreement.
Process risk the risk of loss arising from control/process inadequacies including disaster recovery risk, business recovery risk, people risk, front-office error risk, operations error risk, software error risk, authorization risk, structured product risk, authorization risk, regulatory compliance risk, documentation follow-up risk and collateral risk.
Profit and loss (P&L) explain process a method of decomposing daily earnings/losses and relating them to starting risk positions, intra-day activity and market movements to determine the true source of earnings.
Put option a financial contract giving the purchaser the right, but not the obligation, to sell a specific asset at a predetermined strike price.
Recoveries amounts received by creditors after bankruptcy proceedings have taken place (e.g. senior, unsecured creditors might recover 30–50 cents per dollar of exposure after proceedings).
Regulatory compliance risk the risk of loss arising from failure to comply with regulatory rules related to authorizations, authorized dealing personnel/business lines, reporting, and so forth. A subcategory of process risk.
Repurchase agreement (repo) a financial transaction involving the sale, and future repur- chase, of securities for cash. Through the exchange, the repo party is effectively borrowing money while the “reverse repo” party is acting as lender.
Reverse repurchase agreement (reverse repo) a financial transaction involving the pur- chase, and future sale, of securities for cash. Through the exchange, the reverse repo party is lending money while the repo party is borrowing it.
Risk-adjusted return on capital the return earned on capital allocated to any risk-bearing position in direct relationship to the amount of risk being taken; risk-adjusted capital permits the true return of different risk positions to be compared on an equal footing.
Risk framework a set of risk limits used to constrain various classes of risk exposures. The framework can be used as a limit structure and risk/exceptions monitoring tool.
Risk mandate a firm’s risk operating guidelines, defined to include its risk philosophy and risk tolerance.