Regulatory Camouflage

My faith in government institutions and the people working for them has been restored by Martin Wolf of the FT when he pointed out an excellent paper "Why Banks Failed the Stress Test" by Andrew Haldane of the Bank of England. Reading this is a complete contrast to my experience at the FSA presentation on stress and scenario testing the other week (see earlier post).

The paper ends by putting forward five proposals for improving risk management:

• Better Scenario Definition - Regulators defining multi-factor scenarios for the industry that are truly representative of extreme tail events.
• Regular Scenario Evaluation - A common set of scenarios evaluated and reported upon to the regulators on a regular basis.
• Second-Round Stress - Making sure that the consequencies of stress testing for individual institutions can be evaluated for system-wide risk.
• Active Management of Risk - Ensuring that management take and can explain actions that provision for the risks identified, and do not simply passively report on risk levels.
• Transparency - Access to institutional stress testing results by regulators and potentially by the market as a whole through annual report and accounts.

In addition to solid content, Andrew Haldane writes a good story, and I love the usage of "regulatory camouflage" in the serious point below:

"...is that stress-testing was not being meaningfully used to manage risk. Rather, it was being used to manage regulation. Stress-testing was not so much regulatory arbitrage as regulatory camouflage."

A lottery of bonuses

Another application in an FT article of the long-dated option strategy (see earlier post) this time to discredit the UK Government's attempts to limit the risk of the short-term bonus culture in financial markets. The article is funny and makes a lot of sense, but the need to "do something" for the outraged public will unfortunately mean that not many politicians will take any note of it.

Data management, derivative analytics and the spreadsheet

Interesting article out doing the rounds on the newswires announcing a forthcoming report called "The Enterprise Spreadsheet: Pushing towards Transparency" by the analyst firm the Tabb Group. It is great to see an analyst firm acknowledging the importance of spreadsheets within the markets, particularly in the area of combining data and analytics together in OTC derivatives management (see earlier post).

Adam Sussman of the Tabb Group reckons that despite its shortcomings, Excel is a valuable tool: “Spreadsheets, either alone or in conjunction with other components, can meet the same requirements as a business application.” In this he seems to be agreeing with the UK Regulator the FSA, who have been recently advocating that spreadsheets and spreadsheet data needs actively managing as an institutional resource. The findings of the Tabb Group on management also seem to echo a recent report called "Buy-Side Data Management in a Changing Landscape" done by Lepus for Asset Control (registered link to report here).

Spreadsheets are a great tool and fulfil a real need in the market to pull together pricing models and data quickly, easily and with a timeframe that is meaningful to the business (see earlier post for some work by Xenomorph in this area). Spreadsheets are a big problem to manage, but they are also the symptom of failings in core systems that are not able to rapidly support new instrument types and pricing models. An institution that ignores analytics, spreadsheets and spreadsheet data within any EDM transparency initiative has already failed before it begins, and so to paraphrase the author Aldous Huxley:

"Spreadsheets do not cease to contain data because they are ignored."

The Respect Scenario from the FSA?

The presentation by the FSA last night on their consultative paper called "Stress and Scenario Testing (CP 08/24)" was a real disappointment last night. The presentation was at best average, not adding any more value than what you could get from scanning their paper. However, what was worse was the Q&A session at the end, with a variety of questions from the audience being answered by the FSA representative with "Thanks, that was a very good question and I will get back to you on it...".

The organisers (ISDA and PRMIA) had managed to get around 200 risk managers to attend which was an impressive turn-out with only standing room left as the event started. I would suggest if the FSA want more feedback from the industry it would be better if they would send someone along who is at least able to add value to the conversation. Their representative last night was doing his best but was just too junior, too inexperienced and lacked the confidence to answer questions in a meaningful manner.

Regulators are telling everyone to "raise the bar" on standards at the moment - they would find it helpful if they would apply this mantra to themselves and the people they put out as representing their views and expertise.

What Investment Banking is all about?

I admire the boldness and openness of Richard Jory, Editor of Structured Products Magazine, for asking the serious and under-answered question whether it is a problem or not that the likes of the equity derivatives division of BNP Paribas lose 1.5 billion Euro in one quarter after making around 15 billion over the past five years? Certainly there is an automatic rush to condemn such losses given their size and the current context of the global financial crisis.

The first sentence of Richard's article should be framed as an excellent and apt piece of prose - I am not sure he is behind the times or predicting a future return to investment banking normality:

"Losing a lot of money in one year, or one quarter after making a whole truckload of money in the preceding five years is, frankly, what investment banking is all about."

Not sure he will find many regulators backing his view, but let's see...

The "Bubble Index" Cometh...

Seems like my idea of detecting and hedging against future economic price bubbles via a "bubble index" (see last paragraph of earlier post) is maybe not so stupid as I might have thought judging by a letter in the FT today. If only innovation were more popular at the moment, it might have commercial legs!

Don't just say the numbers, count!

Teachers at my son's school gave a presentation the other night, on the methods they use to teach maths to him and his classmates. Amongst a lot of interesting stuff, I thought one topic that was particularly profound was when a teacher explained that for a five year old, being able to count the numbers up to 20 was not the same as being able to count. This had initially surprised the teacher until she had seen several children behave the same way, and she gave the example below.

Let's say that they are four chairs around a table, and the teacher asks the child to count the chairs. Most children point at each chair and as you would expect say "One, two, three, four" in turn. Apparently though, if the teacher then says "So how many chairs are there?", many children look baffled and either repeat "One, two, three, four" or alternatively just guess, saying any number that comes into their head. At that age, the children do not necessarily know that the last number is the special one, the "result", and many do make the connection between saying "number words" in order and actually "counting" things.

Doesn't sound like much to do with the current financial crisis, does it? But maybe it is, as to me there seems to be a real parallel between too many compliance, product control and risk management staff who concentrate on the task of "producing" a management report rather than the real task of understanding and interpreting its meaning. Like the teacher, managers shouldn't be surprised at this and need to make sure the desired "result" is understood rather than allowing staff to "say the numbers". Thinking about it, maybe after the past six months it would be best if we all went back to school for a while...