How to make a simple task complex

“Our capital markets and much of the ‘plumbing’ of the financial system … rely on confidence in the integrity of the assets being traded,  in the robustness of counterparties, in the reliability of infrastructure. Crises nearly always involve that confidence sliding away.”

Paul Tucker, Deputy Governor for Financial Stability Bank of England April 2011

The New Year offers an opportunity to provide you not with another forecast of what may happen during 2012  but to outline what can be done now to protect  against further growth degradation and make credit easier to access. I read a great deal of opinion but little provides real and actionable advice that can help Real Economic activity. I’ll go through some background, what’s gone wrong and how credit is being eased. Links provide further background and reading to the major points.

The financial infrastructure connecting creditors and debtors is broken. Many of the methods, tools, assets and instruments used to intermediate liquidity to borrowers in the Real Economy have lost the trust of investors. Growing doubts about the ability and willingness of Private Non-Financial Corporations (PNFC’s), Financial Institutions and Sovereigns to meet their future payment obligations has turned a systemic liquidity crisis into one of general solvency and confidence, depressing growth in advanced economies. There are now signs of emerging market contagion.  The background to the crisis is well summarized here:-

This is indeed a credit crisis, in two senses. First, its most urgent symptom is banks’ inability to continue their social function of providing credit to society: there is a liquidity crisis. But underlying this symptom, there also is a credit cause for the crisis. This is the neglect of the basic accounting fact that every credit is accompanied by a debt. In that sense, the credit crisis really is a debt crisis. Society has neglected to ensure that credit would be directed towards self-amortizing investment, with real returns that would allow the paying off of debts. Instead, credit flows have led to the accumulation of debt, balanced for a time by rising asset values. Their plunge left the banking sector with a large net debt, ruined balance sheets and incapacitated to serve the economy well.

Over the last 30 years, consumption, investment and growth became increasingly dependent on credit. Following the introduction of the 1988 Basel Accord, Credit Intermediaries (CI’s), mainly banks at that time, were required to hold minimum levels of regulatory capital. The commercial banking model built around accepting deposits  and extending loans became increasingly costly as loans were essentially assets retained on the balance sheet.

Fortunately for Financial Institutions, growth in structured finance (and shadow banking) enabled assets (or synthetically contrived derivatives of underlying asset pools)  to be packaged into credit instruments. These comprised tranches with different seniority of claims on the cash-flows of the assets referenced by the instruments. Each tranche had a risk profile that enabled sophisticated market participants to match a yield with their growing risk appetite. These methodologies enabled banks to “de-risk” their balance sheets with both legal and audit approval and provided an additional and valuable source of fee income; intra-financial credit. However, the de-risking was make-believe. When liquidity dried up in 2008, contingent liquidity support from sponsoring funders was called upon by “orphan” vehicles engaged in ‘off balance sheet’ (IAS 39 under IFRS and FIN 46R, FAS140 under US GAAP) transactions where crystallizing losses on triggered credit events would have fallen on the balance sheets of sponsoring funders.

However, the gap between the cost of credit and price of debt  grew. Asset price growth was increasingly driven by complex debt issuance rather than underlying performance. This complexity meant that modest imprecision in evaluating the underlying risks and their exposure to systemic risks caused fragile ratings to implode and the financial infrastructure to collapse in 2008.

Complexity and personal incentives for CI’s and market participants created risk myopia to modeled reality. This reality was based on information generated by the CI’s themselves using Advanced Internal Ratings-Based credit models (or national supervisors under Standardized and Foundation- IRB models) and the credit rating agencies paid by the Security issuer.

The failure of the system to adequately price credit and therefore debt has resulted in speculative and productive credit ‘sliding away’. The priority of governments is to fix the latter; the former comprises considerable financial sophistry of questionable merit to Real Economic activity. This can be highlighted by the fact that in the US alone, from 1952-1990, $1 of debt created around 70¢ of GDP growth. During the 1990‘s this fell to 33¢ and then 22¢ by 2007. The financial sector grew from being the same size as the US Real Economy in 1952 to nearly five times GDP by 2007. Real Economy credit, on the other hand, has supported self-amortizing production and consumption of goods and services, and left no net debt growth beyond the nominal growth rate of the US economy.

However, there is now a dangerous dependence on Central Banks to ease bank solvency concerns. Easing credit therefore cannot solely be the responsibility of funders, politicians or regulators. PNFC’s must prepare for further economic turbulence by creating robust funding structures supporting trade and growth that:-

  1. Improve Capital allocation and returns: Shareholders and capital market investors demand higher risk premia and granularity in securities in return for liquidity.
  2. Reduce Credit risk: both real and perceived affect confidence. Improving the timeliness of data is essential.

Better Financial Market collaboration

The regulated insurance sector can play a far bigger role in funding the Real Economy. They have risk absorbing balance sheets and have to date avoided financial contagion with one notable exception. However, the sector faces it’s Basel III moment with the rollout of Solvency II regulation in Europe.

Financial Institutions willing to remove themselves from life-support must use more precious capital to tailor better offerings that fit clients needs whilst meeting their own commercial interests. This does not mean “lending less” as so many bankers have suggested. Proven solutions are currently in use that can help PNFC’s bring forward future investment and reduce the likelihood of credit events affecting solvency helping to restore trust between borrowers and funders. These solutions necessarily blend insurance and banking techniques as routes to capital markets continue to converge for sophisticated financial market participants. Bankers not au fait with Solvency II are unlikely to propose solutions that use insurance techniques at the expense of existing  relationships within the non-insurance financial sector.

PNFC’s are reducing costs in order to maintain or  increase operating margins. Optimising operating cash flow value is critical to survival. However, as macro-economic conditions deteriorate across Europe, and the banking system relies on the ECB, financial covenants for some sectors will undoubtedly come under increasing strain through 2012.

There are real concerns about systemic banking stability and the lack of credit. Very simply,  PNFC’s must optimize internal funding costs if they are to minimize external funding requirements and costs. The traditional funding structures, vehicles and mechanisms used by PNFC’s must evolve.

Abundant secured and unsecured bank debt  contributed positively to global trade, social well-being and GDP growth following WWII. However, as debt becomes harder to access, funding structures must adapt. They should rely less on illiquid, deflating assets. They should, ideally, support Real Economy growth by focusing on addressing the following key areas:-

  1.  Non-bank credit (PNFC – to – PNFC): Approximately twice the value of bank and non-bank debt owed by PNFC’s. Outstanding invoices account for ~60% of working capital needs & are a $18 trillion asset value in US alone or ~$70 trillion worldwide.
  2.  Better allocate  capital for all transaction parties.
  3.  Forecasting and valuation models which proved less than robust prior to ’08, should rely on timely and verifiable data.
  4.  Clearer Financial reporting, supporting independent audit and internal control procedures.
  5.  Redefinition of financial claims upon the Real Economy which reduces potential for a future crisis.

Trade receivables are a PNFC’s contractual promise to pay a fixed amount at a future date. Again, from here:-

“All money is credit. Money is the expression of an accounting relation of liability and asset, created as one agent extends credit to another, who assumes a debt. (Therefore the study of money and credit is au fond a study in accounting.) Such IOU’s are monetized and made into a tradeable instrument typically backed by the state’s authority; in other words, money is ‘transferable debt’.”

Trade invoices are a real asset second only to property and their portfolios are significantly under-valued by as much as 20% in funding transactions. Funders treat them extremely cautiously as they are highly granular and change daily, making the tracking of credit risk (systemic and individual) very hard. This is reflected in inflated risk premia in funding margins charged by funders and in also in conservatively over-collateralized advance rates.

Trade invoices are a corollary of productive credit and economic growth; a financial asset that can support far greater diversified non-bank funding in the US & EU, already used widely by US PNFC’s. Updating existing financial infrastructure and methodologies reduces risk premia and increases the quantity of credit extendable. Tailoring better financial transactions for PNFC’s unlocks economic capital, removes significant valuation uncertainty and mitigates funder credit risk more effectively than existing methods (invoice discounting, factoring, trade receivables securitisation, ABCP programs,  Revolving Credit Facilities and orthodox ABS & ABL) at lower all-in cost. This is achieved by addressing credit opacity; a central cause of the financial crisis. Uncertainty about a PNFC’s exposure to their debtors or its location are one part of the problem associated with tracking systemic credit risk as Lehman proved. The other is monitoring any portfolio with granularity that changes daily. These problems reflect in unrepresentative Probability of Default and Loss Given Default calculations used to price credit. The credit study linked to earlier suggests:-

“Credit is, of course, vital to any economy, enabling households and firms to make choices about whether to spend now or delay for a future time.  There are conditions in which it would play no active role, passively reflecting cyclical fluctuations in output, employment and inflation. In a world of more or less complete transparency between borrowers and lenders, very low transaction costs, and very low risk aversion, access to credit would not be rationed; and ex ante yields on financial assets, including loans and bonds, would not embody risk premium.  So if households and firms wanted to bring forward spending in the face of shocks to the economy, they would be able to do so restricted only by their need to remain solvent.”

Increased visibility of granular credit risk exposures enhances decision-making under uncertainty for PNFC’s and financial counterparties, reducing risk premia and transaction costs, enabling credit to be eased.  National banking supervisors will
show sensitivity
to banks attempting to meet increased capital requirements whilst maintaining lending, particularly in Europe. New funding methodologies that increase transparency reduce complexity and opacity. To suggest opacity is good for economic development is to miss the contractual heart of the relationship between debtors and creditors that has been broken; a promise. What is more, most of these ‘promises’ were made between ‘sophisticated’ financial professionals in a culture that didn’t question  epistemic arrogance; a culture led by a few confident -but risk myopic- executives loosely controlled by passive investors; Main Street played little active part. However, we should avoid the ‘blame game’; our role in asset inflation was passive. We allowed our savings to be invested by a system of professional investors without sufficient checks and balances in the Principal/Agent relationship. We are paying for it now.

Information asymmetry cannot be eliminated from finance. However, egregious systemic failures can be designed out with with more progressive regulation. Those holding important public or private roles should operate within decision-making frameworks defining clear risk authorities contractually bound by employment and remuneration contracts. A fair system ‘incentivizes’ through bonuses and maluses, particularly when the costs of these risk failures fall on society disproportionately.

As an ex-catastrophe underwriter I discussed corporate governance and risk management with Energy company CFO’s. Some would say, and I am sure believed, that their company had a ‘zero tolerance’ policy for loss of life. However, as so many man-made disasters prove, few executives were subject to Hammurabi’s code.

It is unsurprising social cohesion has become strained since 2008 in many economies. The banking crisis has exploited an obvious fault-line. Rewards for taking risks with positive economic outcomes were paid to individuals. Yet when risks crystallized into losses with high economic and social cost, they were borne by society. This situation is not unique to banking.

Blending Insurance and Funding processes to ease credit
The funding process begins by creating timely risk information, adding external finance functionality and updating it daily. The PNFC (entities with a turnover of £5m+) then assesses it’s own credit risk appetite and tolerance. A transaction is structured that achieves the desired accounting treatment and outcomes for the PNFC and funder. Credit risk intelligence supports a transparent funding process for investors/funders. The structures and instruments achieve far stronger and more visible protection of principal/capital at yields that reflect more timely and granular risk transparency and improved PNFC corporate governance and risk management.

Risk management and corporate governance therefore become a source of competitive advantage. This flies in the face of the popular narrative that it is “risk-takers” who create wealth. Those who take it with their own money, yes, that is true. But there are fewer of those than the popular narrative suggests. Return on Capital is not the same as Risk-adjusted Return on Capital.

Insurers already support Risk-Weighted Asset optimisation through the provision of eligible (N.B. not traditional trade credit insurance) Credit Risk Mitigants to funders.
In exchange, an insurer assumes the buyer credit risk (with conditionality written to the funder) for 100% of monies advanced against eligible invoices. Increased risk transparency enables advances to increase and/or expected funding margins to be reduced by more than 1%.

Bank Internal Rating Based Models are currently unable to sufficiently optimize Risk-Weighted Asset exposure amounts for Real Economy assets. Improving banks credit risk monitoring and expected loss forecasting methods with better risk transfer structures improves PD, EAD and LGD verification and asset valuation methodologies. These funding methods are adaptable for large PNFC’s or to attract private funds for SME PNFC’s funding facilities as insurance risk can be effectively transformed into capital markets risk. Swiss Re’s Crystal transaction is one such example. Each Credit Instrument is underpinned by a credit tool that uniquely improves credit risk underwriting for banks, insurers and investors.

Financial infrastructure must evolve and track debt and credit values at a granular asset level if skeptical investors are to be assuaged. Mitigating credit risk effectively is vital, as traditional CRM tools are scrutinized for regulatory arbitrage.

Clearer documentation and funding structures can reduce complexity if underpinned by a highly visible and shared credit risk monitoring platform. Each transaction participants capital more effectively reflects their explicit credit risk appetite with the credit platform helping set initial transaction parameters. Legal Entity Identifier risks  reduce and the transaction is supported by daily credit risk monitoring, reporting and valuation at granular, entity and portfolio level. Participants share a single view of trade credit risk presented in a timely manner. This addresses a serious fault line of the financial crisis, information asymmetry.


  1. Reduce “all-in” funding costs and Improve Returns on Equity/Capital.
  2. Improve credit access by allocating transaction capital based on clear risk appetite.
  3. Reduce reputation, liquidity & systemic risk.
  4. Improve cash-flow forecasting, financial reporting & Internal Controls.
  5. Enhance Enterprise-wide Risk Management.
  6. Diversify funding and create a more sustainable approach to funding.
  7. Expands funding capacity for clients exporting to overseas customers.
  8. ‘Joined up’ approach to the internal and external management of credit risk for funding tailored to PNFC’s with greater resilience to external funding shocks.
  9. Create new, transparent asset pools that can be structured to attract private sector investment and bank funding that, in Eurozone, can act as collateral for ECB funding.

In 2001, the Bank of England studied risk transfer between banks and insurers. However, little developed given abundant availability of bank credit to the Real Economy before 2008. Basel III and Solvency II now enable insurers and funders to materially improve funding outcomes for PNFC’s with turnovers of £5m+.

The balance sheets of PNFC’s, insurers and reinsurers can collaborate better and more transparently to reduce funding liquidity risk and increase liquidity and credit.
Risk-Weighted Assets are the denominator for regulatory capital calculations. Their impenetrable complexity can be simplified. Evidence of better risk intelligence compared with existing bank portfolio credit assessment methodologies, helps differentiate effective bank and transaction risk management to prospective bank investors.  These solutions reduce the regulatory capital charge of a funding transaction for a non-investment grade PNFC by 50%+ subject to individual credit underwriting judgement. However, central to each underwriting judgement is higher quality initial and ongoing risk information supporting higher quality PNFC risk management, financial reporting, audit and corporate governance structures. Society wins.

Rules aren't always enforced.

“Trust in Me”

from Walt Disney’s  The Jungle Book

Trust in me, just in me
Shut your eyes and trust in me
You can sleep safe and sound
Knowing I am around

Slip into silent slumber
Sail on a silver mist
Slowly and surely your senses
Will cease to resist

Trust in me, just in me
Shut your eyes and trust in me

People ask me why it’s so hard to trust people,
and I ask them why is it so hard to keep a promise. – unknown

I was at Royal St. Georges in Sandwich on Saturday  attending The British Open. A friend (someone I don’t do business with) generously invited me. I was lucky to receive a clubhouse pass.  Having gone to school in Sandwich, it was a childhood ambition to visit this famous sporting venue. I duly wore the required jacket and tie and ventured into the clubhouse to find some people tie-less, wearing shorts and sweaters. “Oh well”, I thought. “They know the unwritten rules”. I kept my tie on. I wasn’t confident enough to break the rules my hosts had asked me to follow. This clubhouse is a microcosm of the bonhomie, hospitality and friendships’ that can be found across political, social and corporate institutions in the Global Village. Membership or access to these  institutions is similar everywhere; Invitations are a gift and dress codes varies. But the rules follow a familiar pattern. Punishment for rules broken are set by members . Criminal laws are rarely broken. Committees write rules and set membership criteria to ensure decency is maintained.

The clubroom is the type of place where the behaviour of Kaa, the huge and powerful 100 year old Python in The Jungle Book who sung the song in the Disney film quoted above, is observable. It is easy to see how those invited to attend  or seconded to become members (Decode: ‘I put my trust in this man [it is usually men]; he is one of us’) are seduced to believe they are being offered this privilege because they:-

1. deserve it because of educational/employment/ historical family endeavour.

2. believe they will fit in well as they share similar values and mix in the same social circles as others attending.

3. Sing from the same hymn-sheet/play by the same rules. Even these phrases evoke social etiquette.

It is therefore all too easy to draw analogies with schooling. Many of the privileged who are destined to lead are birthed through a system that developed in English Private schools centuries ago. They begin by being subservient to prefects. When the victim (or Special Adviser as they are known in Politics today) eventually became a prefect it was a rite of passage. They hadn’t enjoyed being bullied. But when you finally become a prefect, you’d earned the right to behave in an unwritten yet authorised manner. Most found it a rather nice club to belong to. Fellow prefects support you when questioned by authority particularly if you’ve held a minors head down the lavatory pan for a little too long. Or worse, as the late John Peel the hugely respected DJ told of his own school days, you had to give prefects manual relief and accept forcibly buggery. Those are the rules.

Similar tribal corporate behaviour  can be recognised in many Institutions past and present, though the buggery is unlikely to be  literal. Whilst Enron published all the data in their Financials prosecutors later relied on for legal discovery in the Enron trials, their auditors, Arthur Andersen, chose to shred information claiming it was routine and denied criminal activity. Probably no similar to what it is claimed News Corporation have allowed to happen to email correspondence. However,  information now being discovered in the News Corp hacking case went undiscovered by the Metropolitan Police phone hacking case for years even though it was under their noses. They claimed they had more important things to focus on, a most remarkable claim. The thing is though, it wasn’t necessarily in the interests of the overseers to find the information. Who wants to hear bad news from someone you’re paying? So more dangerously, it was in the interests of the prefects to cover it up. This highlights what many call a ‘Systemic risk”.

In the  1970’s and ’80’s, the entitlement culture was knitted into the British social fabric and epitomized by the Lloyd’s of London scandal. Many people were encouraged to use their assets to become an individual Name, underwriting risk in exchange for a share of the profits in the Lloyd’s Market. Many were allowed to bet their homes believing their returns would be even higher; to squeeze the pips as they may say.  Membership of this exclusive wealth creating institution would be an investment Wonka golden ticket nurtured and shared at social events. The tickets became a badge of honour. “Made a bit of money at  Lloyd’s. Paid for our holiday villa. If you want, I’ll put you in touch with our Managing Agent. You can trust him. He’s a member of our club.” Stresses within the Lloyd’s of London insurance market increased as asbestosis losses mounted. As the insiders knew, many outsiders weren’t aware of the accounting treatment called “Incurred But Not Reported” being used to estimate losses.  This was a creeping and growing long-tail liability enabling industry insiders to exit their positions on Syndicates with heavy asbestosis exposures as fresh outside money poured in following a recruit to dilute campaign. Some may now call this a Ponzi scheme. Families lost their homes because they trusted like-minded people. The Old Boys Network had failed its own. Well the Old Boys Network has been democratized. It no longer guarantees trustworthiness or proper behaviour  as Royal Ascot recently proved. Not, of course, that it ever did.

The entitlement behaviour  exhibited by those who have had a taste for power is all-pervasive. It no longer matters what your background is. It is the destination that’s shared. When people are promoted to the Institutional equivalent of a prefect they begin to enjoy dinners and lunches at fine restaurants, special hotel rates, invitations to corporate functions and to speak at overseas conferences. As the executive slopes are climbed, the stakes increase;  trips on yachts and private jets, the use of acquaintances holiday villas,  invitations to Davos, newspaper and magazine profiles, Restricted Stock Units, executive pension schemes ; in fact benefits that are argued by many to be a sadly necessary entitlement for those at the top. For some, this lifestyle becomes impossible to disengage from and encourages risk myopia.

Of course, not all executives play this game. There are plenty of good, quiet people at the top of private and public institutions who eschew much of this behaviour and fly below the radar because they have true competitive advantages the rest don’t have; so the rest rely on spin.  So emphasis on the rules becomes particularly important in exclusive clubs. Moving in those circles, you learn how to shortcut and interpret rules and become aware of rules that can be overlooked or carry small penalties. This ensures entitlements continue to roll as long as members understand committee rules and play by them. Seeking the truth and unearthing risk become secondary issues.

However, the law in finance, business and politics are complex. It would be cynical to suggest they have been constructed to be so. Yet this is the only clear outcome of opacity. And this complexity no longer offers the automatic defense those on the inside have been able to rely on. Nor are other members able to back up those who have failed to comply with the big rules. The world is increasingly embracing social networking and transparency. The genie is out. This is shaking to the foundations those who have benefited from the entitlement culture to the core and relied on personality. This culture has been encouraged over many years within social systems. The cult of personality is a phenomenon cultures have been built on. Whether it is bankers, Members of Parliament or corporate executives, legal compliance used to be sufficient and personality would do the rest. No longer. Reputations no longer correlate with legal heuristics. A legal opinion can be sought that offers whatever outcome is sought as defined by the carefully drafted frame of reference. Lehman’s repo 105 was a classic example of legal arbitrage. The confluence of US GAAP, IFRS, English and NY law created opacity. It was legal. Just as everything Enron declared in their financial releases was legal. Supposedly.

Boards or Committees must now re-balance control in boardrooms filled with powerful and well remunerated characters. They must prove to shareholders they have strong governance structures. Progressive Boards understand good governance creates economic advantage. Strong controls ensure outcomes follow documented decision-making procedures if the company is to minimize reputational damage from errors that are a necessary and everyday part of business. These governance structures identify, quantify, monitor and control adverse events. They clarify how decision-making processes are escalated through the corporate hierarchy when events crystallize or exposures grow. Such processes enable losses to be minimized. They ensure executives responsible for taking risk-related decisions that influence their key performance metrics are accountable.They do not allow payments of £700,000 to be paid without thoroughly checking the veracity and legality of the payment. At AIG, expense management was forensic. £130,000 to an external agent such as Glenn Mulcaire would have been authorised by someone within their expense authority limits. Sadly, at AIG non-insurance underwriting was not so forensic.

Good governance will increasingly require better disclosure. This isn’t an issue for legislation; it is an issue of reputation. Disclosure should include corporate hospitality received by Key executives identified as such by Boards. If they’ve nothing to hide and hit targets legitimately and without threat to the corporates reputation through exceptional performance, no-one should deny them high levels of remuneration. However, governance should uncover those being carried and who use a big spade to bury. Only this level of transparency can begin to rebuild trust with investors in publicly-listed companies and many other types of public institution.

Whether it was Greenberg’s or Murdoch’s wish to hand control of “their” companies to their children, the challenges (beyond clear and ironic in Murdoch’s case inheritance tax concerns) for both were/are the same. Both octogenarians had a strong Wall Street following. Both talked of employees as members of The Family, treating them as such when misfortune struck. Both men railed against traditional establishments. However, both pleaded ignorance of illegal acts carried out under their watch within a corporate culture they built in their lean image. Their networking skills were legendary. Their relative positions in China evidence this. But question a decision they make or methods they employed and their irascible characters emerged. They understood The Law. Their fingerprints were never on the paperwork involved in illegal acts. They sought to crush political opposition. There is nothing inherently wrong with this when you have right on your side. However when you are wrong, continuing to claim you were right in light of clear governance weaknesses is damaging. Covering up these weaknesses devastates economic value as people begin to ask “what next?” Reputations, that took years to build can be destroyed in weeks. Share prices slump. Powerful CEO’s are hard to remove. Whilst moving your ball illegally on a golf-course means you are a cheat, few CEO’s are ever accused of cheating. However, shareholders are cheated out of economic value through the damage done to corporate brands and share price as the search for yield encourages risk-takers to push the boundaries of legal acceptability.

It should be sufficient to influence policy responsibly through transparent and observable channels. But developed societies haven’t been built that way. Social events are the convivial meeting places for club members. See and be seen; have a quiet word. Network. These two extraordinary men and their lieutenants ignored the ambulances picking up victims as their limousines traveled along the global superhighway.

The last three years have undermined these club rules. There has seen a massive loss of confidence in political and institutional governance processes that shows little sign of returning. Social networking is dissipating fear amongst the hitherto silent majority. They are no longer willing to trust those who simply ask for it. Now, they are asking their political and corporate leaders “how aligned are our mutual interests?’; “How accountable are you?”. The discount required by shareholders for the gap between what companies say in their Corporate Social Responsibility program for example and what they actually do is growing. Boards who ignore this gap should do so at their peril not just their shareholders. In News Corporation, they call it the Murdoch Discount. AIG too had a Greenberg Discount during the Spitzer investigations. There’s a trend…

Let’s be clear. Trust developed between the public, the traditional media (for years an establishment conduit) and the political and corporate establishment has been knocked in many areas. We were taught to believe that those at the top were exceptional, worthy and either altruistic (public servants) or wealth creators (corporate leaders). Reversion to mean has begun. CEO’s pay grew to ridiculous levels of 100, 200, 300 times employee average earnings.  Middle ranking employees were paid well to not point out risks. These may have meant earnings targets were missed and CEO key performance indicators like Return on Equity or Earnings per Share weren’t met. Promotion would not happen; “keep your powder dry” was a common phrase shared with the conscientious. We’re back to prefects and the bullied.

Yet what the last few years have uncovered is how easy it was for those at the top to make decisions that risk other people capital before their own entitlements. Even now, I question the settlement offered by UK politicians to the Metropolitan Police Commissioner and Assistant. Those with power find their remuneration senior to shareholders, voters or those who fund their lifestyles. Without clear accountability for financial and reputational risk and governance overall, pleadings of ignorance no longer hold weight. It is irrelevant when the Murdoch’s knew. They knew there was an adverse event crystallising as soon as Brooks opened her mouth in the Select Committee hearing in 2003. Legal compliance is no longer enough. The question is not “Did you know this was happening?” but “what did you do to stop laws from being broken and adverse events escalating? Please provide the written controls in respect of expense authorisation”. Maybe too mundane for a red top headline where things are black and white.

Greenberg/Murdoch wrote the rulebooks that helped them grow complex and diverse organizations and change their respective corporate landscapes. The control they had – like those of financial wizards in the build-up to the global financial crisis – was based on the club membership illusion policymakers bought into. Like Enron, they were all within the letter of the law. They were Masters of The Universe.  The lawyers ensured this.

This is no longer the case. Trust can only be restored by continuing to draw back the curtain on wizards insistent on hiding behind. This should not reduce their accomplishments. But it s essential for Boards, committees and Judicial reviews to address clear flaws in the policing of institutional governance and executive accountability that are the are fundamental to so many recent systemic failures. We can no longer rely on club committees to decide the application of rules or membership when Society is forced to pick up the cost of their failures.

Oh, and as Darren Clarke proved, good guys do win.

The comment “risks cannot be reduced only transferred” has received some recent prominence. This post develops my response to a post that used this phrase in answer to a question on LinkedIn’s Financial Services Regulation group; “How do you govern risk if you have no visibility into your risk? How do you identify risk? If you cannot identify risk, you are unable to mitigate it.”

It gives me an opportunity to build on a point The Epicurean Dealmaker raised in his 2007 blog”Nobody Expects the Spanish Inquisition”, a four year old but timeless commentary on the use/abuse of credit derivatives and risk transfer.

“Risk is incompressible: it cannot be eliminated, only transferred (for a price).

TED makes clear  he is referring to risks associated with derivative insrtuments. Risk transfer between financial institutions frequently focuses on transferring irreducible risk associated with a third-party entity that neither the seller or buyer can directly influence through their actions. So financial institutions lobby to indirectly influence outcomes. Currently, we are seeing this influence being exerted across the Eurozone where the Olympian “Game of Finance” is approaching it’s final stages. Cost of entry to watch this game is high, everyone can be assured of a ticket allocation as the ticketmasters have our tax details and the cost for adults is lower than it is for chidren.

For 20+ years I worked in the regulated insurance  industry. It is impossible for protection buyers to profit from an adverse catastrophic event that crystallizes losses to identifiable assets of certain value which the buyer has no insurable interest in.  “Regulated” insurance,? Insurance entities where policyholders assets are ring-fenced in the event of the entities failure for the benefit of policyholders. Many financial commentators use the term “insurance” for some financial products. this is a fertile fallacy that pays off for market participants who use it. “Insurance policies” or “credit risk mitigants” are often no more effective than soluble umbrellas or chocolate teapots wrapped in a thin, porcelain skin. Insurance policies cannot be leveraged or valued at multiples of its nominal value. In the regulated insurance world, protection buyers interests align with those of the sellers. Continuously and actively seeking to mitigate the probability of an occurrence and/or the consequences of a sudden and unforeseen catastrophic event benefits both parties. It is an anathema in regulated insurance for one participant to profit from anothers risk blindness.

It helps to understand that risks/adverse events and their economic costs fall into two categories. Events:-

1) we can influence by our thoughts, actions and behaviour dependent on the strength of Internal Controls & governance for example.

2) we cannot influence by our thoughts, actions and behaviour such as earthquakes.

In both categories, the size of economic losses are directly influenced by decisions that are taken before and after the occurrence of an adverse event. However, our actions can both trigger an adverse event and influence its outcome in only one of these categories; endogenous as opposed to exogenous risk. This is where the role of effective governance is key.

Identifying adverse events which can be triggered by weak internal controls and their effective mitigation is a primary function of a company’s Board. When structured effectively, risk transfer creates a positive feedback mechanism that reduces not only the probability of a catastrophic event but also it’s cost. Essentially, Unlike banks, regulated insurers cannot “profit” from adverse events they underwrite. This is because credit risk transfer between financial market participants seeks to capitalize on risk asymmetries and the destruction/arson of economic value in a zero sum game. Collaborative risk transfer, on the other hand protects and creates economic value. For example, by reducing the probability and cost of an adverse event that reduces cash-flow and increases credit risk, effective governance and risk management can help ensure Capital costs don’t spike. But this point will not be shouted from the roof-tops by many corporate financial advisers. They rely on traditional financial methodologies and tools to generate fee income. They focus little on how their clients manage risk. Taleb’s Procrustean Bed is still the only accommodation financial institutions are willing to offer their customers. In the world of complex financial markets, only sophisticated financial participants understand “risk”. And the adverse events non-financial companies have been taught to fear most (& which drives executive remuneration in most companies) over the last fifty years is damage to their cost of Capital. BP’s historical approach to risk management and transfer offers a tangible insight.

AIG collaborated with BP to create risk transfer structures dealing with adverse events such as fire, explosion, earthquakes, floods and windstorms. The positive feedback mechanism relied on identifying risks in large complex and highly hazardous facilities. Risk engineering programs ensured industry-wide risk management best practices were shared and Probable Maximium Losses calculated  for counterparties. Underpinning this was AIG Global Energy’s broad understanding of industry loss events, trends in proximate causes and relationships with Original Equipment Manufacturers. Ten or so years ago, BP elected to self-insure. As I recall the reason given by the Company Secretary was to allocate Capital more effectively. What followed is history. Now, it would be wrong to conclude that losses occurred because this feedback mechanism stopped. However, it is indicative of a fertile fallacy taught by business schools over the last 40 years. Financial Markets demanded consistency & predictability in earnings growth forecasts. Short-term growth in profitability and Return on Capital Employed took precedence over Risk-Adjusted Return on Capital. This oversight is costing societies hugely. “Efficiency” may remove redundancy and overheads that improve  short-term ROCE and lift earnings expectations. But an adverse event can cause significant damage to cash-flow and earnings. This increasingly leads to confidence draining fast from investors and trading and funding partners as rumours sprea, weak crisis management fails to suppress this volatility and share price falls.

Corporate Boards owe their shareholders a duty of care to prevent adverse events from causing significant loss. They are responsible for establishing Internal Controls that protect against adverse events. A simple example may be to retrofit buildings in an earthquake prone area to voluntarily comply with updated best practice engineering that reduces the loss impact. This isn’t just complying with minimum legal requirements. This is doing far more. As the quality of financial, physical, political or corporate  structures have shown over the last few years, accountability at the top of organizations is poor. There are a tiny number of vocal policy “architects” who have become financially bloated not because of any directly attributable management skill but because of  credit their companies gorged on, self-belief and erudition. Rather than take their medicine, they have passed the costs of their  disease onto taxpayers. Until politics addresses the issue of accountability more fully ( and David Cameron has been mentioning it a great deal) , it is unlikely that many of the politically disillusioned will agree that we are “all in this together”.

The loss outcome for a company whose buildings are damaged by an earthquake is essentially no different to outcomes from other adverse events which their employees actions can trigger. But risk identification is lax in many Boards.  If a Board required reporting of any adverse event on the 30th day of each calendar month, executives would find it impossible to take timely decisions that limit the size of a loss event triggered on Day 1. Shareholders would laugh at such a weak internal control. Fortunately for Boards “Risk Managment” is low profile. In News Corp’s 2010 Annual Report there is no mention on “risk management”.  This quality of governance and risk control occurs in many, many companies. A Board can approve a CEO’s strategy to increase RoE by reducing the ratio at which it replaces old equipment. This can take place by extending the life of old equipment. This is likely to increase the probability of a catastrophic loss. However, making that decision in year one may not cause a loss for ten years, by which time the executive has left with their remuneration intact. Executives should be held accountable for these types of decision that increase the probability of a loss outcome in Extremistan. Rule one of Risk Management 101 must be accountability.

We’re seeing the effects of poor accountability and governance at News Corporation. An adverse event that first became “visible” to the Board 8 years ago is now escalating with a significant potential cost to shareholders. This failure suggests fundamental Internal Control weaknesses. This was coupled with a reliance on “legal opinion” regarding allegations made against News Corporation on whether a risk event had occurred. Lawyers aren’t the most objective risk hunters; Like truffle pigs, they look for what they have been trained to look for within tight terms of reference. Adverse events do not wait for a “legal opinion” before triggering.  This is a significant oversight by many Boards.

I had first-hand experience of Internal Control failures; not only within an organization run for many years by a strong-minded, driven and successful octogenarian who bulit the company over 40 years ago, but also as a catastrophe underwriter for hazardous industries and unaccountable executives worldwide. Risk visibility can be suppressed in a Culture driven to”outperform” rivals. “Don’t bring me problems, bring me solutions” was a common phrase at AIG by executives who signed off your bonus. Yet, many executives will say “Risk is a necessary part of capitalism” as if there is good risk and bad risk.  Others pay lip-service to safety. “We have a zero tolerance for loss of life” they used to tell me. However, I knew their remuneration was barely aligned with this outcome. It is human nature for us to believe we are “good” people doing the “right thing” as we believe we are all better drivers than the average. This leads to misinformed comments (hubris?)  such as “we will have a laser like focus on risk.” Nassim Taleb calls it epistemic arrogance.  Executives generally only see risks that will impact their remuneration. Allowing a successful CEO to build a company in his image works until it doesn’t. No CEO should be served by their company’s shareholders. News Corporation shareholders are now asking themselves tough questions.

How do we begin to put this right ? First, let’s drop the fallacy that Systemic Risk is confined to financial markets; it isn’t. It is endemic across corporate entities. Strengthening Internal Controls is central to addressing the risks of adverse events. Complex organizations need a Chief Risk Officer (CRO) who :-

1) report directly to the Board, Chairman ,CEO or Risk Management Committee; not to the CFO.

2) has responsibility for internal audit/policing; not lawyers, accountants or non-execs who should support the process.

3) protect the reputation of the listed company.

4) draft clear contractually binding Risk Authorities for identified key executives whose decisions can cause catastrophic adverse events. These Authorities should align individual goals with corporate goals and governance. If these include Corporate Social Responsibility policies, words and deeds can be aligned. The public will be sure to note any misalignment.

5) Act as a conduit for whistleblowers.

This is one of the only ways I can think of – except for lengthy and ineffective regulation – that the trust that has been broken between shareholders and Boards of companies who have suffered reputational harm can begin to be repaired. It is also voluntary.

The CRO is the person who, on behalf of shareholders, asks the tough “what if” questions regarding Return on Equity/ Return on Capital Employed metrics driving most executive compensation schemes. “What-if” uncovers the “risk-adjusted” element to be mitigated.

The conceit of those supporting the “ROE/ROCE” performance agenda and opposing RAROC is that they are the risk takers & dynamic wealth creators. Over the last 30 years, Piper-Alpha, BP, AIG, Lehman and now News Corp have shown the economic cost of weak Internal Controls. Those seeking to impose stronger Internal Controls have been considered a cost-centre who hinder economic development and reduce economic growth.

This conceit is dead. CRO’s may increase the sustainability of the Net Present Value of future cash flows at a cost of a few basis points less of short-term income or RoE. But this cost doesn’t  get close to the estimated $60-200Trillion of NPV of economic growth lost during the global financial crisis that Andrew Haldane of the Bank of England has suggested.

Time to bury the fertile fallacy that people with a strong risk focus are poorer at delivering economic value and growth than CEO’s focused on ROE/ROCE, maximising their remuneration at ultimate cost to shareholders and society. Companies with a strong risk focus will not only ultimately win, but will be seen by investors as having both eyes on the road.