June 12, 2008
Basel II or Babel II?
And so it came to pass!
[Genesis 11:1-9] 'And the whole earth was of one language, and of one speech' and they said 'Go to, let us build us a city and a tower, whose top may reach unto heaven.'
The story of the Tower of Babel is a parable of hubris. The universally true message is that, notwithstanding the grandeur of any plan, nothing will get built if the builders do not communicate with one another (i.e. Project Management 101).
But the architects of Basel II are nowhere near as ambitious as the builders of Babel. They do not wish to reach unto the heavens, merely 99.9% of the way there. Then again, since no one knows how far away the heavens are exactly, we have no way of knowing when we will reach within .1% of them?
The religion of Basel is 'Mammon', with 'Efficient Markets' and 'Principles Based Regulation' making up the un-Holy Trinity. Risk Based Capital is the Holy Grail, except the search for this elusive treasure is beginning to look more like Monty Python than the Da Vinci Code. The disciples of Basel are aiming to build a great fortress in which to contain this precious Capital, lest the Prodigal Lender squanders it.
The 'conceptual' foundations of Basel have been laid, albeit on the shifting sands of the sub-prime crisis, and the builders are already in. The Europeans and the Australians are frantically building a wall apiece, but the Americans have decided to slow down, debating exactly how many occupants the finished dwelling will have. Some of the Asians have asked to see the plans again because they don't like the design. Critics have noted the absence of plumbing - the architects have completely forgotten liquidity. No one has yet informed the client that, if the walls are not the same height, the regulatory 'floors' cannot be put in place. The builders are not working to the same timetable, nor it appears to the same plans.
This blog does not have sufficient megabytes to describe all of the small, but potentially divisive, variations in how different regulators have interpreted the overall Basel blueprint. However, one aspect provides an insight into the problems to come.
In the Book of Basel, when seeking to qualify to use an AMA (sounds like an Eastern deity?) to calculate Operational Risk Capital, a bank must consider 'Four Fundamental Elements': (1) Internal Loss Data; (2) relevant External Loss data; (3) Scenario Analysis by experts; and (4) the ghostly and unknowable BEICFs (unfortunately, not another Eastern deity but the more prosaic Business Environment and Internal Control Factors). In their edition, the US banking regulators refer to the 'Four Elements', no 'fundamentalism' here. Meanwhile, in their textual translation (in this case from English to English), APRA, the Australian regulator, have chosen to refer to the 'Four Key Data Inputs'.
Four Horsepersons of the Apocalypse more like? Chaos is bound to ensue, because, not only are the Four Elements (fundamental or otherwise) ill defined, they may be combined any way that a national supervisor considers fit! This is like everyone mixing mortar using different proportions of cement, sand and water; all very democratic, but hardly a recipe for constructing a solid lasting structure.
When Basel II is eventually finished, what will it look like? Could it be the majestic soaring spires of Chartres Cathedral, or the Walls of Jericho, ready to tumble at the first toot of the trumpet of economic reality? Or maybe the Mayan Pyramids or Stonehenge, where we marvel at the ingenuity of the builders, given their primitive tools, but ultimately have to ask the question: what in Heavens (or Hell) was it all for?
The author is well aware that the rabid rantings of a regulatory agnostic will not dent the resolve of the builders of the New Financial Jerusalem but hopes that sometime, far in the future, a financial archeologist will stumble upon the half-finished overgrown, abandoned edifice and notice the graffiti scrawled on the entrance, the Devil is in the detailing.
Posted by pjmcconnell at 04:26 PM
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June 02, 2008
SG + PWC = MIA
Societe Generale's report into the Kerviel 'affaire' is a whitewash!
While this is not entirely surprising, it is perplexing that, after so much criticism of large audit firms in previous scandals, PriceWaterhouseCoopers (PWC) has allowed its good name to be used to bolster such an obvious snow job.
The Societe Generale (SG) report of 25th May 2008 is, in fact, three separate reports, by different bodies. The first report is by a Special Committee, consisting of 'independent' directors, of the very Board that allowed the loss of EUR 4.9 Billion (some $ 7 Billion) to take place. This report relies heavily on the second report by PWC, which is entitled 'Summary of PWC diagnostic review and analysis of the action plan'. Both these reports focus mainly on the 'action plan' for 'transformation of the control methods for market activities'. The reports are forward looking, attempting to assure shareholders and regulators that the bank will achieve a "new balance between the objectives of profitable growth and risk management".
The tone of the Special Committee's report is incredibly self-congratulatory, for example: 'Thanks to the actions of Senior Management [i.e. ourselves] since the discovery of the fraud - the majority of the negative effects of the fraud on the Bank's business situation have been overcome.'
So what negative effects precisely have been overcome? The share price is languishing some 30% below its level before the detection of the fraud, Q1 profits have fallen by over 20% year on year and, so far, Monsieur Kerviel is not reported to have coughed up the $7 Billion. Maybe the canapes in the Directors' dining room have improved? So pleased was it with its efforts, the Committee wound itself up, having 'completed its assignment'.
Because its terms of reference were purely to look at the measures already proposed by the senior management of SG, PWC confined itself to analyzing managements' proposals and making recommendations as to how such an 'ambitious programme' may be managed. The overall programme may be summarized as 'more of the same, then even more of the same'.
Admittedly it is all very laudable to move quickly to put in place changes necessary to ensure that a similar disaster does not happen in the future, but such an effort is only meaningful if the underlying causes of the problem have been properly identified. Otherwise, it is just wasting time and money.
For the analysis of the events leading to the loss, both the Special Committee and PWC relied exclusively on the third report into the 'fraud committed by Jerome Kerviel (JK)', published by SG's 'General Inspection Department' (equivalent to Internal Audit).
Herein lies a major problem. Not only is the bank investigating itself, it is doing so on an extremely narrow basis - very specifically: the details of the fraud; the mechanisms used; the motives; the specific failure of controls that assisted the fraud; and a general check that the same mechanisms were not being used in other parts of the SGCIB (Corporate and Investment Banking) division.
In other major trading failures, such as Allied Irish Bank (AIB) and National Australia Bank (NAB), the Boards of these banks called in truly independent investigators and gave them a mandate to look at structural in addition to control failures. In these cases, and others such as Barings, investigators found faults not only with controls in the trading environment but also with Risk Management, Internal Audit, Senior Management, the Board's Risk Committee and the Board itself. Regulators also were given considerable stick.
In their investigation at SG, the Inspections department did not find any fault with itself (what a surprise!) nor with the Board, nor with Senior Management, again hardly surprising, since biting the hand that feeds is rarely appetizing, even in French cuisine.
A second and ultimately much deeper problem with the Inspectors' report is its stunning reluctance to ask the simplest question - why?
The report is peppered with many examples of pure naivety. For example, an 'alert' was raised on some 'fictitious transactions' in January 2007 - note a full year before the fraud was detected. When asked why nothing was done about this alert, the answer came back that 'procedures were followed by Middle Office but no initiative was taken to verify the truth of JK's assertions or to transmit the information to immediate superiors (actions not explicitly called for by procedures)'. In other words - we were just following orders.
Similar answers for other important alerts were given by the Back Office, the Risk department, Accounting, the business line and on and on. The Inspection team appeared not to have asked the most basic question: why did no one tell senior management? Inspector Clouseau is alive and well and living in La Defense, Paris.
From the information provided in the Inspectors' report there would appear to have been serious deficiencies in SG's 'risk culture' that permitted staff in multiple departments to simply ignore potentially grave problems. As recognized in other risk management failures, and demanded by Basel II, a strong 'risk culture' must start at the top of the organization. Firms that fail to recognize the importance of a coherent risk culture, as demonstrated in this case by the Special Committee of the SG Board, are asking for trouble.
Openness, transparency and a willingness to face unpalatable truths are hallmarks of good risk management, but these are sadly missing from the SG reports. On the contrary, the attempt by the bank to fob off a tawdry report as serious analysis, merely illustrates the corporate hubris that caused the Kerviel problem in the first place.
Which brings us back to PWC. While SG management may be expected to try to cover up its deficiencies, PWC appear not to have asked the question that the Inspection department failed to ask - why did no one tell the Board? In the fine print of their report, PWC admit that 'we were not instructed to assess the overall relevance of the conclusions reached by the General Inspection department' - it appears that they, too, were just following orders! Furthermore, PWC noted that 'we did not at any stage carry out procedures designed to attribute responsibility.' This is from a firm that identified one of the 'key success factors' of the proposed programme to 'transform' cultural change to be to 'foster a sense of responsibility on the part of the players.' Would SG know responsibility, if they saw it?
Of course, PWC is a relatively minor player in these events; it is the regulators of the banking system in France who have gone 'Missing In Action (MIA)'. If the French Banking Commission needs some advice on how to handle the situation, they merely have to pick up the phone and talk to their colleagues in APRA (the Australian banking regulator) who, although admittedly late to the game, showed how to apply muscular regulation to the Board of NAB in similar circumstances.
Regulators should ask the tough questions: Why was the bank allowed to get away with a purely internal inquiry? Why were the terms of reference of the Special Committee, General Inspections department's investigation and the PWC assignment set so narrowly? Why, ultimately, was the problem let grow to the size it did without senior management and the Board not doing something?
As they say in France: 'Je ne sais pourquoi' - I don't know why. Nor apparently does SG or its regulators!
Posted by pjmcconnell at 04:35 PM
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