Confronting the perils of risk

Faced with escalating risks to reputation, profitability and from regulation, financial firms are on the back foot.

Risk is a growth business. But today, the focus of many financial firms is less about the trade-off between risk and return, and more about simply managing a proliferation of menaces, hazards and dangers. Anticipating risk, preventing it, monitoring it, mitigating it and, ultimately, paying for it are a primary concern.

There are three broad categories of risk, according to Tommy Helsby, chairman of Kroll Eurasia, a leading global risk consultancy. These are market, credit and operational risks. It is a helpful taxonomy, but the categories often merge, and deficiencies in one usually have an effect on the others.

"Assessing the nature and level of risk-related costs suffered by financial firms is complicated," he said.

Tommy Helsby, Kroll

The 2008 crisis exposed multiple layers of market risk, even for those financial institutions that did everything else right, such as implementing effective management, compliance, and credit analysis systems. And for less competent firms, the fallout revealed inadequacies and even illegalities where poor operational systems were in place, heightening the credit risk for other firms exposed to them.

Meanwhile, managers were (and in some cases still are) deflected from actually running their businesses, instead focusing on crisis management.

In addition, losing counterparty status to other firms can mean losing clients and important accounts. A company's solid reputation can soon dissipate.

Loss of reputation
"Reputational costs are real," stressed Helsby. Obvious examples are the UK's Lloyds TSB and Royal Bank of Scotland, where managements have spent the past three years coping with the costs of customer defections. In the US, Citi and Bank of America are still trying to re-establish credibility, and in the insurance sector, AIG was a terminal casualty.

The Western banking and credit crisis and the greater levels of scrutiny once apparently untouchable institutions are now subjected to, means that managing risk seems a more reactive discipline than during the boom times.

"Financial firms are now especially vulnerable to damage to reputation, loss of customer confidence and from greater regulatory scrutiny," said Stuart Witchell, senior managing director of FTI Consulting.

But, "when there are allegations of wrong-doing, some firms don't act quickly enough to address the issues.

Too many firms brush problems under the carpet and end up handling an escalating crisis badly," he said. FTI Consulting responds by mitigating any reputational fallout through independent investigations by specialists in forensic accounting, technology, investigations and crisis communications. "Subsequently, we can assist with tightening internal controls, liaising with regulators and providing additional risk prevention measures."

Risk consultancy firms can help firms manage the continuously changing regulatory environment in which they operate. "But, we focus less on specific regulations, more on the attitudes of the regulators and of those being regulated," said Helsby.

Before 2008, the game played by many financial institutions was regulatory arbitrage, and the result was often "regulatory capture", with the enforcers reduced to a subservient role. Since then, global regulators are working together, diminishing arbitrage opportunities, and have recaptured the authority they had lost. Now firms have to be much more conscious of compliance issues.

"Compliance officers are now increasingly perceived as the key defence against getting into trouble with the regulators," said Helsby. "But, the compliance department shouldn't act like a police force; instead should work with the business to nurture and develop a culture of compliance."

Kroll helps compliance departments run internal investigations of systems or governance violations. Self-reporting of failures can then mitigate any regulatory offence. Kroll might also examine reporting structures, uncover anomalies and so pre-empt future problems.

Stuart Witchell, FTI

Preventive action is important in all areas of risk management. At its most basic level, this might mean reference checking. Kroll does more detailed checking of CV accuracy and potential employee screening — and might dig deeper into a candidate's personal reputation if the post is a senior one.

Kroll also works with financial firms to mitigate credit risk by investigating the backgrounds and claims of potential counterparties in individual transactions, and by setting up due diligence systems and processes that are used throughout a firm. The process for exhaustive checks for specific deals is part of a model that Kroll set up 30 years ago; the systematic examination of all new business relationships is more recent and has meant that the due diligence role has shifted from bankers to the compliance department.

"Our task is to identify where a problem might lie and where there might be a weakness in a business transaction or a firm's wider operations that could be exploited by someone determined to act dishonestly. In effect, we kick the tires and check the engine," said Helsby.

It is important to realise that the market and operational risks for setting up a business in emerging economies is very different from those in developed economies. Many European and US firms simply adopt due diligence templates used in their home markets, but in Asia (and emerging markets in general) they need to dig deeper. Often there is "too much reliance upon public information from the internet and not enough understanding of off-balance sheet issues and a misunderstanding of cultural nuances", said Witchell.

In Asia, FTI is active in China, especially for Foreign Corruption Practices Act (FCPA) assignments, and increasingly in Malaysia, Indonesia, India and Philippines. Also, it conducts due diligence work for Japanese companies planning investments in China, Vietnam, Thailand, Cambodia and Indonesia.

FTI's global risk and investigations practice includes checking out counterparties for specific transactions and reputational due diligence on investment targets or existing investments for asset managers. But, for reverse takeovers (RTOs) the firm also acts for the Chinese companies themselves through Special Audit Committees to add greater credence to their claims and to reassure investors. Indeed, "investigating Chinese firms to substantiate their pre-listing claims and researching those firms that have undergone a RTO in the US is a substantial part of our Asian business at present", said Witchell.

Seeking economic justice
Perhaps the most sexy work for Kroll and other risk consultancies during the past two-to-three years has been on behalf of receivers to recover cash and assets lost by smaller financial institutions that went bust. Kroll has reportedly investigated bank collapses in Iceland, Ireland and Bahrain, although the firm declined to confirm its involvement.

"The objective is to recover money through the civil judicial process that was illegally obtained by managers or their associates through fraudulent loans. It's clearly not right that people should benefit when they might have effectively looted these institutions and then were protected by limited liability. Financial recovery is our mandate," said Helsby.

In general, despite the high-profile instances of egregious crime — Madoff stands out — well-regulated jurisdictions experienced less financial fraud.

Interestingly too, Asian financial institutions came out of the global crisis better than Western firms. They suffered their own crisis in the late 1990s and since then have introduced better internal controls and more prudent business practises.

Alternatively, a cynic might say that they had less capital and access to credit, so they didn't have the same opportunities to "bet the bank".

But, the inter-connectedness of markets makes everyone vulnerable to a failed financial institution.

Kroll conducts forensic examinations, following the trail to documentation, assessing whether correct procedures were followed and then identifying the location of the missing cash. The receivers might subsequently agree a negotiated settlement because cash recovery not law enforcement is the key goal.

"Our aim is to deliver economic justice," said Helsby.


This story first appeared in the August 2011 issue of FinanceAsia.

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