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July 12, 2007
Who is up for a trolley of Herstatt?
An interesting trend that is beginning to amuse me is the ever increasing segmentation of exposure types. Only a few years ago, perhaps one generation and well before ISO 9000 standards on quality existed, banks in general really only saw risk in a handful of domains. The first is an obvious play because it in itself is the merchandise of underwriting risk and is well known as the business of insurance. Staying in the domain of putting a value (dare I say a bet) on a threat would also take in the business of market based investment which is known to most as market risk and this is defined by the Basel committee as the risk of losses in on-and off-balance-sheet positions arising from movements in market prices. The pure domain of choosing to put funds at risk or not would also translate to lending and credit risk features very heavily in the Basel Accord. Today however I look up on some of the risk news sites and we have a whole shopping trolley of risk products including but not limited to interest rate risk, energy risk, weather risk, political risk, country risk, model risk and a new comer 'Corporate Defense Management'. The latter I personally see as an extension of operational risk, none the less people are talking about it even though one does have this real sense that some of the community out there are creating their own spins on an event to lobby their circumstances favorably. These people seem to wrap up a threat in risk classification propaganda to give it credibility and fear, then sell the world a panacea to such a pathogen.
Now if I were to ask you 'Do you know your Herstatt Risk'? You'd probably ask what are you going on about Martin and yet Herstatt risk is the very creature that kicked this whole risk regulation game over in the world of banking.
So what is this Herstatt thing?
The regulators certainly know what it is and to them it is one of the worst demons of all risks because it could result in a total melt down of the financial sector specifically where institutions owe each other payments but have not settled. So where did it first arise?
In 1974 a bank in Germany known as Herstatt was closed by the regulators leaving all its foreign-exchange positions open and unpaid, swiping an institution with an asset base of back then DM 2.07 billion in a matter of hours. Quite spectacular are the words the Bank For International Settlements now uses. Before Herstatt most threats created by banks were localised and manageable however Herstatt brought the world to a scary awakening through its foreign exchange business. In the end that foreign exchange business amounted to an unbelievable loss that was four times the size of the banks capital base.
Herstatts first mistake was to speculate on dollar appreciation and depreciation cycles which unfortunately for Herstatt moved in the opposite direction to their predictions. The problem was not so much in their strategy and for what its worth this is not the first or last investment strategy that fails on a market. The Herstatt case is unique in that the bank had 'borrowed' to finance their positions and they did this by taking foreign currency receipts in Europe and not making any of the US dollar payments.
Herstatt embodies a type of settlement risk which results from alternate layers of transaction settling in different time zones or perhaps where a banks netting system between segments of its clearing and settlement process is flawed in its workflow. Where foreign currency or asset backed swaps are involved Herstatt risk has a real potential to present itself especially with banks that have not mapped their clearing and settling procedures thus leaving pockets of fund catchment open. In the actual Herstatt bank case the institution was closed by the regulators sharply and even though the bank had taken payments for specific transactions and issued orders for more receipts, the US payment component did not clear because the US banking hours were behind that of Germany. The whole process was so convoluted that the three largest German banks that attempted to organise a joint bail out of Herstatt failed, there was simply a total lack of transparency about the magnitude of positions that had been taken and there were so many parties carrying the weight of the transactions it was extremely difficult to untangle. In the end a committee was formed to assist in the liquidation of Herstatt.
This committee and the potential magnitude of the event prompted many nations to also establish a central body for banking supervision which was passed into the Bank For International Settlements and just one year later that very committee adopted its 'Basel Concordat'. Basel Concordat put emphasis on host and home country authorities to share the supervisory responsibility for local banks entertaining foreign activities and was an outcome of Herstatt. So while so many risk analysts out there may never have heard of Herstatt, it very much affects their lives today. The Basel II accord is so globally impacting that it has been reckoned by many in the market as being the most impacting regulation pressed against financial institutions to date.
Posted by CausalEvents at July 12, 2007 03:13 PM
If you consider the term corporate defence to represent an organisation's program of self-defence aimed at protecting and safeguarding the interests of all of its stakeholders, then I would agree that "Corporate Defence Management (CDM)" is not a new risk, but more a method for managing potential threats. It has been said that what we now refer to as "operational risks", were previously simply seen as the risks related to the management of an organisation. One notion, which revolves around the risk and reward principle, suggests that operational risks are very often viewed by the board of directors as not actually generating rewards. While this may be somewhat simplistic a view, it does unfortunately explain why many operational risk managers believe that it occupies a somewhat subordinate position within the broader risk management domain, seemingly deserving of a lower priority than market or credit risks. Some critics would also argue that the performance of the real day to day operational risk tasks have been further demoted by the priority being focused on the development of quantitative financial projections and being overly concerned with issues such as capital adequacy allocation requirements etc. It is therefore not surprising that many books and discussions on operational risk are almost exclusively devoted to such topics. The appearance of Enterprise Risk Management (ERM) was therefore seen by many as an attempt to reinvigorate this field on an enterprise-wide basis. It is however still argued by some that with ERM also, sufficient attention is not being focused on the human aspect within the organization, and that the health and safety, well-fare and wellbeing of individuals as human beings cannot be measured in purely quantitative financial terms. Therefore this numbers based approach does not resonate with all of the stakeholders within an organisation, often resulting in a top-down, but not a bottom-up, buy-in. The result being that in many organisations ERM issues simply get stuck at middle management level. This has resulted in an ongoing search for a more suitable solution, and in recent times there has been somewhat of an evolution in the development of cross-functional operational risk type activities, such as "Unified Security Management", "Risk Intelligence", "Governance, Risk and Compliance (GRC)" and "Business Resilience" to name but a few. CDM could therefore be said to be the next logical step in this evolutionary journey, being a cross-functional discipline which recognises the need to co-ordinate and integrate the critical roles of "Governance", "Risk Management", "Controls", "Assurance", "Compliance", "Security", "Resilience" and "Intelligence" within an organisation. Any truly holistic solution needs to address these critical aspects in all areas throughout an organisation, and also importantly, address the responsibility and accountability for operational line management in these areas. Only then will an organisation be in a position to defend the interests of all of its stakeholders (including its people) and establish the foundation of trust essential to fostering the necessary top-down and bottom-up culture required. An increase in effectiveness, the reduction of overheads and the optimisation of efficiencies should thus be the motivating financial reward. In the words of T.S. Eliot, "We shall not cease from exploration. And the end of all our exploring will be to arrive where we started and know the place for the first time".
Posted by: Sean Lyons at July 19, 2007 12:32 AM
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