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Wednesday, 17th April 2024
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ERM - the key to managing risks in treasury Back  
In the first of a two part series, Declan McGivern explains the crucial role enterprise risk management can play in maintaining an effective risk management regime in treasury.
Since the Allfirst affair put a dent in AIB’s balance sheet there has been a flurry of activity within treasury departments (corporate and financial institution) to assuage the fears of directors and management that a similar event could not occur to them. Risk management has become a primary focus for many organisations that perhaps had previously let it slip down their list of priorities. In the context of this heightened awareness Enterprise Risk Management (ERM) has now become a fashionable concept eagerly promoted by consultancy firms and just as eagerly consumed by management. But what is ERM and what relevance does it have for treasury?
Every organisation raises capital and during the course of its venture places that capital at risk in the expectation that they will meet set corporate and business goals. The old adage -’no risk - no reward’ has never been more appropriate than today. Current and future pronouncements such as Turnball, Cadbury, IAS39, FAS 133, Sarbanes-Oxley, - FRS 13 and Basel II are all geared toward proper corporate governance, increased disclosure of risk, capital adequacy and decrease in systemic risk. They are intended to increase corporate transparency by enforcing a culture that recognises, measures, discloses and manages risk. In this current environment of disclosure and focus on the risks enterprises are taking, ERM has become a buzzword bandied around as if it were something new and revolutionary. During the course of this article I hope to demonstrate that most organisations already have many of the components in place but perhaps have not managed to contextualise and integrate them within a framework that is, in essence, ERM.

Background
Past failures to manage risk have resulted in well-documented corporate collapses. In many of these, financial markets or products, allied to a failure in the control environment were responsible. For example I’ve listed below some of the more public scandals:
• Orange County - Structured notes and leveraged repo positions
• Barings Bank- Nikki 225 Futures and Options and JGBs
• Daiwa Bank - Bond market losses
• Sumitomo Corp - Copper trading
• NatWest- Options pricing
• Deutsche Morgan Grenfell - Unit Trust irregularities
• Enron & WorldCom
• Allfirst - Foreign Exchange losses.
What is interesting to note is that in each of the above examples a single individual was responsible and was in a position to by-pass controls. Each one could have been prevented by appropriate oversight. As well as the publicised cases I’ve set out in Table 1 a number of loss events that I’ve come across that are not publicised but amply illustrate the myriad of scenarios that may result in a financial loss arising within treasury. Many readers will no doubt have their own horror stories to retell and the above examples are merely that - a small collection of incidences where things have gone wrong.

FX points banking investment bank
Unauthorised points banking, a procedure whereby a bank lends/borrows FX points with an FX broker. Regulated by the Bank of England in the London market both parties should keep detailed records of all transactions of this nature and reconcile them on a regular basis. However in this instance the two dealers involved had agreed not to record certain of the transactions in order to assist in the cover up of trading losses. Both dealers were disciplined and dismissed.

Pricing information in a retail bank
Mis-pricing of bonds to inflate profits. In this instance the back office personnel were unable to utilise the pricing service provided. They therefore requested dealers to provide process without any evidence that the price was current or that it was achievable in the market. A sharp-eyed ex-dealer noticed the discrepancy and uncovered a systematic mis-pricing of positions over a long period of time.

Unauthorised dealing in retail bank
Proprietary FX dealers have constant pressure on them to perform and generate profit. In this instance a USD/YEN position went seriously offside. The dealer, deciding that his view of the market was correct, began to double up. The dealer was in breach of his daily and overnight limits and over a period of months, having gone undetected, resulted in a realised loss of ?5 million.

Bullying in an investment bank dealing room
Many banks have dealing desks established that specialise in certain specific areas of FX, MM and derivatives. In this case the head of the proprietary desk, a bully, brought undue pressure upon a junior dealer on the corporate FX desk into providing him with offset customer transactions to mitigate trading losses. As profits were scrutinised frequently, a trend of the underperformance on the corporate desk was noticed. The eventual losses being concealed were revealed to be $1 million.
A more recent and worrying epidemic is the advent of corporate scandals where many of the top executives deliberately deceived markets, investors and regulators. Within these organisations there was an endemic culture of deceit. Losses of the magnitude experienced in today’s scandals never used to occur. In the past, macro economic factors were largely the cause of bankruptcies and major losses. Today an individual can lift up the phone and place billion dollar notional bets on behalf of his organisation. Risks can arise today from leveraging positions utilising derivatives, security lending, repos and structured notes. These instruments have injected liquidity into markets and are useful tools in the management of risk but in the wrong hands they can bankrupt an organisation. History dictates that events such as those outlined above are often of such a magnitude that the existence of the organisation is threatened. Any organisation believing itself to be invulnerable could just be in for a rude awakening.

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