It has been suggested that the global financial crisis reflects a complete failure of market discipline, do you agree?
In addition to regulatory failure, a break down in market discipline has been identified as a root cause of many of the problems. Tighter risk management controls would almost certainly have militated against the worst effects of the global financial crisis, if not averted them altogether.
Two-thirds of respondents say the financial crisis represents a complete failure of market discipline. This is in line with a recent report by the IMF . It said that “professional investors in equity and bonds failed to probe deeply enough into the nature of the assets they bought, and instead relied too much on credit ratings.” The problem was that they were “too optimistic” and missed the growing conflicts of interest in credit rating agencies. The IMF argues that market discipline needed to be strengthened, with measures, some of which have already been introduced, to reduce conflicts of interest at ratings agencies and also less reliance on ratings agencies, together with a new differentiated scale for structured products.
Neil D Miller, global head of Islamic finance, Dubai, on the more disciplined approach of Islamic banks to financial risk management:
The creation of sophisticated investment instruments and structured products that were several times removed from the underlying assets became frenzied. Shariah principles suggest that this sort of financial engineering is not a permissible activity and therefore, in theory, demonstrates a more disciplined approach by Islamic banks to financial management.
Dorian Drew, partner, London on the importance of strong risk management:
The global financial crisis has thrown into stark relief the importance of strong risk management processes, which encompass a clear understanding of complex products and how they react to extreme market conditions.
Do you think that better risk management at financial institutions could have helped to prevent the global financial crisis?
Nearly 89% say better risk management could have helped prevent the financial crisis. This is consistent with previous findings from Norton Rose Group surveys that financial services professionals do not absolve themselves of blame. As early as February 2008, 57% of respondents acknowledged that banks and other financial institutions did not have sufficient risk management processes in place, while 74% said the banks were “ultimately to blame for the credit crunch”. In response to a further question, 56% attributed the crunch to “poor business decisions by banks.” The liabilities and losses resulting from those errors are vast. The IMF estimated in January 2009 that total losses from the credit crisis to financial institutions worldwide could rise to $2.2 trillion, a figure that is close to the UK’s gross domestic product in 2008: there are reports that this estimate will soon be doubled. Much of the losses were attributable to structured financial products originating in the US , especially real estate securities, but the IMF also noted “degradation” in bank loan books. According to Andrew Haldane, executive director for financial stability at the Bank of England, “risk management models have during this crisis proved themselves wrong in a fundamental sense.” Banks could soon be forced to take action: the European Parliament is considering an amended version of the capital markets directive under which banks would be required to retain an interest in instruments which they securitise and also to impose limits on interbank lending.
Simon Lovegrove, know-how lawyer, London, looks at the findings of the Turner review:
On its own better risk management would not have prevented the financial crisis. However, as the Turner Review makes clear, improvements in the effectiveness of internal risk management and firm governance are now essential. The Review found that some very well run banks were affected by systemic developments over which they had no influence but there were also cases where internal risk management was ineffective and boards failed to identify and constrain excessive risk taking.
Erwan Héricotte, partner, Paris, looks at the attitude of the French regulatory authorities:
There are already signs that regulatory bodies such as Banque de France and AMF (French financial markets regulators) pay more and more attention to risk management and quality of investment and lending vehicles.
Patrick Bourke, Middle East head of dispute resolution, Dubai, on one of the challenges for the Middle East:
One of the challenges in the Middle East is how a slew of regulation will be implemented to mitigate risk, whilst not unduly stifling commerce and innovation.
Should risk management functions at financial institutions be given an increase in any of the following?
Do you think risk management at financial institutions will in fact be given an increase in any of the following?
Respondents broadly agree that more authority (75%) and resources (67.9%) should be given to risk management functions in financial institutions. Most also think that in fact risk managers will be given more authority (62.9%) while only a minority believe they will be given the resources (47.4%). The majority believes that external advisers, however, should not be given a more important role in risk management.
There is plenty of evidence that risk management has not, until recently, been a high priority for financial institutions. Risk professionals did not traditionally occupy many senior positions with the consequence that risk management was little understood. According to recruitment consultancy GRS, only 12% of UK financial services companies had a risk professional on the board as of July 2008. This is expected to rise to 50% by the end of 2009, with the number of UK financial risk roles surging from 1,000 at the beginning of 2009 to 4,000 by the middle of 2010. GRS said in late 2008 that its research suggested that 56% of financial institutions in London did not understand the risks on their balance sheets. And in a recent survey of the global investment management industry by SimCorp StrategyLab, a third of respondents said they did not actively monitor long-term strategic risk on an active systematic basis, while the number of organisations with a risk management function reporting directly to the board of directors dropped by 5% to 31% since 2007.
Peter Snowdon, partner, London, sees more value being placed on the role of risk management in the future:
A lot of risk models in financial institutions were inadequate, one of the key failures being that they were quite short term: most of them did not see this crisis coming. Risk management as a whole was perhaps not sufficiently valued and given as much importance in financial services as it was in other industries. Regulators are now pushing banks, insurance companies and investment firms to take risk more seriously and to have risk professionals, who have a strong background in risk, on their boards. On the other hand, it is important to place risk management in perspective, as it is quite easy to construct a risk management model that would prevent you doing anything.
Michael Newell, partner, London, comments on the link between good governance and risk management:
Financial institutions know that they must now reassess the link between good governance and risk management. Boards are being encouraged to provide stronger independent oversight of executive management and risk management is now likely to mean greater involvement from non-executives, more risk professionals sitting on boards and an increase in staff for risk management functions. Resource and budget increases for risk management will not be enough, rather cultural changes in terms of personal accountability and a stronger support culture for risk will need to be encouraged. Most fundamentally, firms need to address the challenges of linking remuneration policies to risk management.
Do you think financial institutions should be more focused on remuneration risk/reward structures as part of their risk management strategies?
If yes, where should the focus be?
Respondents overwhelmingly (83%) agree that financial institutions should be more focused on their remuneration structures as part of their risk management strategies. Some 41.6% say the focus should be on senior management level, while smaller minorities highlighted director and trader levels. Previous Norton Rose Group surveys have revealed that many finance professionals acknowledge the need for changes, but these latest responses suggest that opinion has moved even further. In our survey Credit crunch: are you legally protected? (April 2008), nearly 42% said there should be a move towards long term incentives while 40% came out against such a move. Respondents, apart from a minority of nearly 17%, have perhaps been influenced by the public debate. Compensation structures have been severely criticised, and not only in the popular press. While public outrage has centred on a handful of senior executives, a wider problem has been convincingly identified by more sober analysts. The IMF has said that one of the reasons for “market failure” was a “financial sector compensation system based on short-term profits” which “reinforced the momentum for risk taking.” Individuals, it has been argued, have been too concerned with their own short term rewards to consider the long term interests of their companies. The lure of these rewards contributed to the creation of new instruments which were, according to the IMF, “more risky than they appeared.” Already senior executives at banks have reportedly had to insert “no reward for failure” clauses into their employment contracts. International regulators at the Financial Stability Board say that pay should be adjusted for the risks an employee takes, as well as for performance, and should be deferred to take account of the duration of the risks being taken.
In the UK, Sir David Walker, former financial services regulator, is in the process of chairing an independent review of corporate governance in the UK banking industry. The Walker Review is examining a number of board and shareholder risk management issues including the effect of remuneration policies on risk taking practices. A consultation paper is to be published this summer with conclusions due in the autumn.
Peter Talibart, partner, London, looks at the FSA draft code on remuneration:
There has been a huge outcry over bonuses in the financial sector with many concluding that they had a role in causing the financial crisis by encouraging excessive risk-taking. The FSA draft code on remuneration, the Turner Review, the de Larosière Report, the Financial Stability Forum and the G20 summits have all focused on compensation models. Financial institutions will be forced by regulators to look very hard at their domestic and international remuneration structures across all levels, as these are now linked to risk management. The FSA’s draft code on remuneration, for instance, says that remuneration policies must be consistent with effective risk management and that risk management professionals should be closely involved in determining remuneration. It emphasises the importance of risk adjustment in compensation and of moving towards long-term performance measurement rather than simply looking at short-term revenues. Financial services regulatory law has never been so concerned with the individual employment relationship.
In the light of the global financial crisis, are financial institutions more likely to litigate disputes now than 12 months ago?
What will be the main subject of the disputes?
Most respondents (82.6%) expect financial institutions to litigate more disputes amid the recession than 12 months ago. Debt recovery, according to 82.2%, insolvency (63.8%) and structured finance/derivatives (55.7%) will be the main subjects of the disputes. Fraud (45.4%) and employment (30.8%) will also be important areas. In our survey Credit crisis: the long-term implications for a turbulent market (October 2008), the biggest areas identified were structured finance, derivatives, lending and debt recovery and fraud was not identified as an area for disputes at all. High-profile fraud cases involving Bernard Madoff and Allen Stanford have led to a re-assessment of the likelihood of litigation in the area of fraud.
Charles Evans, partner, London, on a more litigious climate:
There is plenty of evidence that financial institutions are engaging in more litigation. In a recession, they are more willing to litigate in order to recover much needed funds and they’re less distracted by the deal making of the boom years. Debt recovery is a big area, as are disputes over the mis-selling of financial products. Fraud is a growing problem as rogue traders of complex financial instruments are finding it increasingly difficult to hide their losses. Some institutions and investors have also found that structured finance products have exposed them to much greater risk than they expected and so they are taking legal action. More and more queries are coming in from investors seeking redemptions from hedge funds and other asset managers, who are often reluctant to give them their money back.
Erwan Héricotte, partner, Paris, predicts an increase in complex cross border disputes:
Many large cross-border transactions have been carried out in recent years, whose complex nature will inevitably result in an increasing number of litigations given the current difficult economic climate.
Patrick Bourke, Middle East head of dispute resolution, Dubai, on pre-dispute positioning tactics in the Middle East:
We are seeing an increase in activity with regard to pre-dispute positioning, analysis of contractual entitlements and obligations and the commencement of formal proceedings. There is already an increasing emphasis on eradicating corrupt practices of fraud in the Middle East, as evidenced by recent comments in the press by His Highness Sheikh Mohammed Bin Rashid Al Maktoum, Vice President and Prime Minister of the UAE and Ruler of Dubai, and Bahrain’s Crown Prince, Sheikh Salman bin Hamad Al Khalifa, who recently announced a possible new corruption law in Bahrain.
Michael Godden, partner, London, on a noticeable change in attitude to litigation:
There has been a noticeable change of approach in banks’ attitudes towards litigation in the last 6 to 12 months. They are generally far less reticent about suing counterparties and many banks seem increasingly willing to countenance the possibility of suing all but the largest players where the losses justify this. While it is unlikely that this represents a permanent change of attitude, the traditional “club rules” about not suing other banks are showing real signs of strain at the moment.