Risk Management and Policy Decision-Making - Essay Example

? Running head: MF Global -Risk Management and Policy Decision-Making MF Global-Risk Management and Policy Decision-Making School: Course: Date: Table of contents 1.0 Introduction………………………………………………………………… 3 2.0 Mf global: failure of key players…………………………………………… 3 3.0 Beginning of the end: defects, weakness in risk management and emergence of the problem………………………………………………………………….. 4 4.0 Risk management; steps and processes that would have averted the problem… 10 5.0 Assessments “The Black Swan”……………………………………………. 12 1.0. Introduction Kerzner defines risk management as the “act or practice of dealing with risks”. It inculcates “planning of the risks, identifying the risks, analysing the risks, developing risk response strategies and controlling and monitoring risks to determine how they have changed.” 1 in large and complex, multinational financial organizations like MF Global, several players play an integral role in the risk management in the firm as well as oversight role that is played by the regulator. Diagnosis of the situation leading to the filling of bankruptcy on Halloween, October 31, 2011, by futures and options broker MF Global, reveals lapses of key players in the risk management process, which led to the giant company going under with reportedly over $ 1.2 Billion of customer money missing.2 2.0. MF GLOBAL: FAILURE OF KEY PLAYERS Various players had a role to play in the risk management processes. They included the management, regulators, investors and credit rating agencies. The management led by the CEO Jon Corzine had the primary role to identify, analyse and planning for the risks, as well as developing risk response strategies and constantly monitoring them to ensure their effectiveness as well as adherence to the legal and regulatory framework. Within the organization, these duties are spread within several departments, and individuals to ensure an internal control mechanism. Consequently, the CEO, directors and risk managers had a direct role to play in risk management processes. On the other hand, the regulators role prior to the filling of the bankruptcy was one of oversight to ensure that MF Global complied with the legal framework including accounting, and disclosure requirements. Following the disclosure that the firm had problems, the regulators intervened, and when it was clear that the damage had been done, a decision was reached that to protect the customers; it was paramount for the company to liquidate.3 With regards to the investors, the panic in taking their money from the company put the company in cash strapped position that led it to engage in panic selling of its assets. Credit rating agencies such as Moody’s and standard and poor’s also contributed to the downfall. They were under fire for waiting, until the last few days, to flag MF Global’s exposure to European debts even though disclosure had been made in May.4 By the time the agencies worked, there were serious doubts among MF Global trading partners and the downgrading the rating agencies only accelerated the downfall of the firm. 3.0. BEGINNING OF THE END: DEFECTS, WEAKNESS IN RISK MANAGEMENT AND EMERGENCE OF THE PROBLEM Upon the appointment as the CEO, Corzine embarked on an aggressive European strategy,5 investing heavily in sovereign debts of other countries such as Spain, Italy, Portugal, and Ireland (which, at the time, were thought to be super -safe.6) The uncertainty of these debts made their yield even more than that of the U.S treasuries. Under his watch, MF Global discovered means to twist the accounting rules. The rules made it to be legitimate for a firm, say MF Global, to purchase an asset, for example, the debts of Spain paying for it using a loan that was secured by the asset. MF Global would derive its earnings from the difference between the interest rate it was earning on the Spain debt and rate it was paying the lender. What happened is that MF Global set these deals in a way that allowed them to book the prospective earnings upfront immediately. Consequently, the asset-the Spain bonds, and corresponding loans were not disclosed in the balance sheet. Some key events preceded the failure. First, there was capital treatment of Repo-to-maturity Transactions.7 This arose during 2010 whereby MF Global started acquiring significant proprietary positions in European sovereign debts; which were financed through an instrument called “Repo-to-maturity” (RTM).8 The firm treated these RTMs as sales under the U.S accounting rules, thereby letting the firm to remove the assets it had pledged as collateral from the balance sheet, while at the same time maintaining exposure to the creditworthiness of the bond issuers.9 Nevertheless, most REPOs are supposed to be accounted for as borrowing while the assets used as collateral remaining disclosed on the balance sheet. Moreover, MF Global contrary to the SEC net capital rules did not take capital charges of the European sovereign debts as required. In essence, what MF Global was doing is that, it was a seller who received the total return on the reference asset, of which it did not own the reference asset but was subject to price and default risk in an off balance sheet transaction, being synthetically long the assets and their attendant risks.10 In such a scenario, the underlying asset must be liquid. However, the European sovereign debts failed to meet this criterion.11 Consequently, it was becoming subject to default and liquidity risks. Though no European country had yet defaulted on the debts, the perception became the reality as the creditors to the firm delivered margin calls dreading for their own welfare. In an effort to meet its commitments, MF Global accessed what should have been segregated customer account. The other event leading to the MF Global failure was with regards to Corzine’s decision to increase the Bank’s leverage. In 2010, MF Global had $ 40 billion in assets and $ 3billion in equity, which was a ratio of 13 to 1. Subsequently by 2011 the same $ 40 billion was buttressed by only $ 1 billion, which translated to a ratio of 40 to 1.12 Some customers therefore ran away and those who stayed demanded additional collateral. To achieve this demand, MF Global employed all credit lines and financial woes grew, it diverted clients’ money, breaking the rule against separation of client funds. The risk in this scenario was thus twofold: one there was the solvency risk: that the Eurozone countries would default and MF Global would not be in a position to have resources to pay back in full the money it had borrowed. But MF Global had a hedge, a $ 1.3 billion short position in French government bonds. Secondly, there was the liquidity risk that would arise from perception: in case the lenders started to get worried, they would require MF Global to put up more money.13 The regulators upon analysing the financial statement of MF Global required it to take remedial measures. As a result of the regulators resolutions, MF Global reported a consequent $ 192 million in 3 months ending 30 September 2011. This negatively impacted on the stock price of the company, with the stock price going down by over 50%. Subsequently, these events led to credit rating agencies downgrading the firm, which due to the negative publicity, culminated in the liquidation of the company. The failure in risk management therefore arose from lack of taking into consideration the inherent risk of MF Global losing money, if say Spain did not pay its debts. The management, faced with a potentially lucrative venture was obligated to first define its goals, identify its risks including its sources and impacts, analyse the risks together with the controls in existence to gauge their effectiveness, evaluate the risks to determine whether they are acceptable or not, determine the treatment of the risks: whether to avoid, reduce the likelihood of occurrence or/and consequence, transfer or retain the risks and finally, monitor and report on the efficiency of risk treatments. All these decisions require authority and fall squarely on the entire management of the firm. The board and the firm had played the inaugural steps of instituting the rules: the corporate governance rules issued on May 2011. Indeed, it had constituted the risk committee, which had 3 board members. However, despite the competence of the board, it is the management that controls the direction of the company irrespective of the value and accuracy of the advice presented by the board. All management decisions were taken by Corzine who dint not entertain contrary opinions. There were people in the company who were not content with both the accounting and the European sovereign debts. As the chief architect and only proponent Corzine oversaw every step of this trading convinced and convincing everybody who cared to listen on the safety of these debts. When challenged by the firm’s chief risk officer and the board on the same, Corzine threatened to quit if they did not trust him. He overruled his risk managers on several occasions and, therefore, the board was under the control of an authoritarian director. Consequently, the rest of the management left the risk management on the hands of one individual who was overly optimistic about these bonds and, therefore, there was a serious lapse in the internal control system. MF Global downfall can be attributed to its decision to trade its capital in the international market.14 Besides Corzine, the regulators, primarily Securities and Exchange Commission (SEC), Chicago Mercantile Exchange (CME) and Commodity Future Trading Commission (CFTC),15 share an equivalent blame. MF Global was dually registered with CFTC as a future commission merchant and with SEC as a broker dealer.16 Regulators, they are supposed to play an oversight role as far as risk management is concerned. The regulator develops the rules for the stakeholders, and ensures compliance with the rules. In the case of MF Global, though, the regulator made efforts to ensure disclosure of the European sovereign debts; it also played a role to the failure of the Firm. Under the commodities Exchange Act 1936, customers assets were supposed to be kept segregated from the firm’s assets so that customers could always get their money regardless of what happened to the firm17. The rules allowed the firms to invest customer’s cash, but only in the safest of assets such as U.S treasuries. However, later regulatory changes made it to be easy for improper conduct. Some of them include the change in 2000 that allowed the likes of MF Global to invest not just in U.S treasuries but also in sovereign debts, which by, then were also thought to be supersafe. Moreover, another change in 2005 allowed such firms as MF Global to lend themselves their customer’s cash and use as an asset, for example, the debts as collateral, all of which were done without the customer’s knowledge or consent. This coupled with the accounting loophole discussed above allowed MF Global to book earnings that might not exist while removing the risk from the balance sheet even though the risk was still looming large. Another of MF Global error was in failing to maintain separate customer accounts. In its last minutes attempt to salvage the firm, the management tried to sell its customer accounts to another firm Interactive brokers.18 This way, the customers would not have noticed that anything was amiss. The latter was to advance an $800 Million to enable MF Global reorganise. The deal, which was at an advanced stage, however, fell through when the shortfall on the customer’s funds was realised and was unexplained prompting Interactive brokers to withdraw. 4.0. RISK MANAGEMENT; STEPS AND PROCESSES THAT WOULD HAVE AVERTED THE PROBLEM MF Global main undoing was failure to manage risks. Business firms exist to take a risk and hopefully profit from them.19 For MF Global, however, the risk appetite20 and tolerance21 was sufficiently communicated.22 Therefore, creating a situation whereby losses occurred to investors and clients who thought that the risk appetite was far below than it actually was.23 Indeed, of the amount of the bet on the European Sovereign Debt, $ 11.5 billion, only half that amount was disclosed to the investors.24 Corzine’s main undoing was the assumption of the role of the CEO and head trader, contrary to the canons of risk management, that demand that the roles that should remain separate. He was not content to remain in the office and only make executive decisions. He was mostly in the floor trading and he would leave even meetings to check on price. Given his ambitions to turn MF Global into a financial elite, and the fact that he took excessive risks, of which he was overconfident could not materialise; somebody else should have independently overseen risk management. However, what Corzine did was that he replaced the CROs who stood to him with ‘yes people’.25 Moreover, he was too large for the MF Global. He inculcated into the bank a culture of excessive risk taking. Even the board easily adopted his ideas without taking into consideration the input of the risk managers and when questioned.26 He once interpreted the board’s questioning of the investment in the euro debts as lack of trust and consequently threatening to quit. Secondly Corzine had overconfidence on the euro debt. Apparently they appeared supersafe just like the U.S treasuries. The problem was that the market was starting to wonder whether the European countries would indeed pay its debts. What Corzine did not take into consideration was how people perceived these debts, and in finance, perception does become a reality. When the people who invest in a financial firm begin to doubt its investment direction, they may demand their money regardless of whether the management was in the right direction or not. Accordingly, this was failure to take into account the psychological perspective of risk, that is, the subjective appraisal of risk. Risk managers ought to consider the perceptions when deciding whether or not to take the risk, as well as when formulating risk reduction measures. This is what happened in MF Global case; because when the extent the firm disclosed the extent of the amount it had bet on the U.S sovereign debts, the investors freaked out. Consequently investors and customers began to flee, alarmed by the firm's massive bet on European sovereign debt.27 This made the firm face liquidity crisis eventually going into liquidation. Therefore, the management ought to have analysed the impact of investor’s lack of confidence in the euro debts regardless of the safety of the debts which Corzine was obsessed with. This would have made the company hedge against liquidity risks which would be apparent, and which brought down MF Global.28 On the contrary the firm had no way to manage risks that its counterparties would ask for extra insurance and it thus had a weak understanding of where its customer’s money was. Lastly, MF Global should have adopted a risk management process while accounting for the repo-to-mature trade. The firm ought to have accounted for the cost of borrowing using the bonds in question as the collateral (using the repo rate) against the eventual coupon payments received from the same bond.29 5.0. ASSESSMENT: “THE BLACK SWAN” Corzine, like Taleb30 says, “Was like a pilot flying a plane without understanding that there can be storms.”31 He was over confident that the euro zone countries would pay their debt and consequently failed to manage the risk that would emanate from perception. He did not consider the possibility of a ‘black swan’32. MF Global failure can only be blamed on decision making errors by Corzine. He was a victim of decision traps.33 First, he exhibited a lack of frame control, that is, failure to consciously define the problems in more than one way. This was, he concentrated only on the ability of the Euro zone countries to pay and forgot to take into consideration other possibilities that would arise from perception of the customers about the firm activities. Secondly, he was overconfident in his judgement. He failed to collect key factual information because he was too sure of his assumptions and opinion. Corzine did not entertain or take into account contrary opinion. The CROs questioned the excessive bet placed on euro bet, but Corzine was over confident they would pay and convinced the board to raise the ceiling of money that would be invested. Finally, Corzine was a victim of short-sighted short cuts, by overreliance on RTMs to secure the foreign debts. Another problem related to overconfidence is confirmation bias. Corzine, like most people do, favoured data that only supported his beliefs. Biases occur because of people’s fondness for evidence that confirms rather than challenges their current beliefs and dismiss evidence that upset them. This leads organizations off course, since any diligence search will evidence that supports a hypothesis even though the hypothesis is not true. This is what happened in MF Global. The CEO had a fondness of only the evidence that the Eurozone countries would pay up their debts and dismissed anything else to the contrary. However, there was evidence that the firm had taken excessive risk in the sovereign debts. When this evidence became public, the public had the hypothesis that MF Global that casted aspersions on MF Global ability to continue as a going concern. This hypothesis may have been untrue given that no country had yet defaulted on their debts. In conclusion therefore, the management failure to adhere to the risk management process, led to the down fall of the company. Risk, which the management should have managed, went unmitigated, and when it materialised, there were no adequate measures to arrest the situation Bibliography. Little A, Demystifying the Credit Crunch, July 2008. Bernanke B, “Risk Management in Financial Institutions”,( Federal Reserve Bank of Chicago's Annual Conference on Bank Structure and Competition Chicago Illinois, May 15 2008) http://www.federalreserve.gov/newsevents/speech/bernanke20080515a.htm Accessed 2 may 2012. 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