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Taming Risky Business

‘Those who forget the past are condemned to repeat it,’ philosopher George Santayana had said. However, if we examine cases where organisations have failed, it becomes clear that we don’t always learn from history.

Here are some instances when institutions failed due to poor risk management processes, and what we can learn from these episodes:

Segregation of incompatible functions: The failure of Barings Bank in 1995, thanks to the machinations of Nick Leeson, a rogue trader in the bank’s Singapore treasury, holds key lessons. Leeson was not only taking big directional bets on the markets but he was also making the entries to settle the trades, enabling him to hide the loss-making trades for a long time. This continued undetected till the bank went bankrupt, and Leeson ran away with a ‘sorry’ note scribbled on his desk. This episode teaches us that critical decisions and transactions should not be left in the hands of one person — the ‘maker-checker’ or ‘four-eyes’ principle.

A similar case happened at Citibank in 2010 when Shivraj Puri, an employee in the bank’s Gurgaon branch, siphoned off client funds to make his own bets in the market. It went sour, burning a ₹400 crore hole. In most well-governed institutions, those advising clients on investments have no control over the client funds.

Marked to model: ‘The markets can remain irrational longer than you can remain solvent,’ goes a quote attributed to John Maynard Keynes. But the market is the final arbiter of value. Lehman Brothers had $600 billion in assets when it filed for bankruptcy in 2008. But a lot of those assets had no liquid market. Lehman valued them based on esoteric models that were too optimistic in their assumptions, and they didn’t hold up when the markets turned.

There are two lessons in this:
It is best to spread one’s assets between liquid assets, which can be easily sold, and less liquid assets.
The model needs to be rigorously tested and externally valued.

Concentration: In 2012, a trader in the London office of a large global bank reportedly lost $2 billion (market sources place it at close to $6 billion) on bets relating to credit default swap (CDS) trades. The bank’s London-based chief investment officer was supposed to use CDS contracts to hedge or protect other investments from credit losses. However, this trader turned the unit into a profitable one, taking large, market-moving bets in credit index-linked CDS contracts, earning him the moniker, ‘London Whale’.

While the bank never confirmed the exact sequence of events, it seems the trader bet on improving credit conditions. Other market participants got to know of his large positions, they placed bets against him. Finally, as the market turned, he could not exit his positions except at a loss, given their large size, and the fact that he had a substantial part of the market stacked against him.
A similar issue occurred with a well-known bank in the US that failed in early 2023. It placed large bets on long-dated government bonds, reputed to be the safest assets from a credit perspective. However, it did not hedge against mark-to-market losses due to interest-rate changes. This led to catastrophic losses and a run on the bank. Moreover, such was the hubris of the bank that it was functioning without a chief risk officer (CRO) for eight months. Its commercial operations were taken over by a different bank in a ‘shotgun wedding’ brokered by the Federal Deposit Insurance Corporation.

The lesson here is that no one — not even the most ‘visionary’ among us — can see the future. So, it is best to diversify one’s investments. And no matter how confident you are about your decisions, hire a good risk manager who will provide you wise counsel.

Good risk management, however, is not only about hiring a hotshot CRO. It is also about setting good processes, organisational structures and culture by the leadership team, as Peter Drucker said, ‘Culture eats strategy for breakfast.’

The writer is Raghuvir Mukherji, Head, Risk Management, 360 ONE Wealth.

Read the original article:

Economic Times