The Need for Continuous Monitoring and
Assurance of Financial Transactions.
Miklos A. Vasarhelyi – KPMG Professor of AIS, Rutgers
Business School, Technical Lead, AT&T Laboratories
Michael Alles, Associate Professor, Rutgers Business
School
Alexander Kogan, Professor, Rutgers Business School
Outline
1.Why don’t we learn?
2.The anatomy of a crisis
3.Monitoring financial institutions
4.A proposed solution methodology
5.Issues for research
1. Why don’t we learn?
Why don’t we learn?
• In 1997/1998 LTCM failed precipitously forcing the Fed
intervention to coordinate 16 banks to contribute close to 4 bi
dollars to shore up an institution largely deregulated that was
operating with leverages around 30 times capital, ignoring even
their swap and derivative positions
• The total effect on the economy, justifying the Fed’s action was
estimated to be about 1 trillion dollars
• Among the major players for countertrades and financing for
LTCM were Bear Sterns, Chase, and Merryl Lynch
• The epilogue was that these firms escaped largelly unscatted
and recovered their investment and loans with positive returns
in about 18 months after Mr. Greenspan’s interest lowering
Why don’t we learn? (2)
• Greatly contributing to the crisis, net of the different
international currency crises, were
the total lack of transparency of LTCM positions
the ignorance by counterparties of LTCM of their intricate web of
relationships and exposures
o the nearly totally unregulated nature of hedge funds
o the immense greed of both LTCM partners and their
counterparties
o the lack of disclosures on derivatives by all parties
o
o
Why don’t we learn? (3)
• Since those days (10th Year anniversary celebration of LTCM)
o
o
o
o
o
The FASB issued derivative disclosure rules
Many other types of financial instruments continue to be non-reported
under the guise of competitive impairment
As private equity and hedge funds remained largely unregulated and
Sarbanes increased the onus of regulation a large amount of funds was
routed to these entities
The financial institutions refined the use of SPElike entities for their funds
The amounts at serious risk are now in the hundreds of billions not in the
pittance amount that partners were forced to contribute at LTCM
Background considerations
• The ill defined nature of the boundaries of business
entities making them outside the scope of existing audit
practice.
• The inability to fully assess the value at risk from
financial instrument and contracts.
• The interlocked nature of financial entities and
instruments that are being measured,
• Even seemingly sophisticated real-time controls have
weaknesses stemming from their own lack of security,
monitoring and alarm handling features.
2. The anatomy of a crisis
Six waves
8
6
5
2
4
1
3
Su
b
pri
me
Deri
vativ
e
Instr
ume
Hed
ges
&
Priva
te
S
w
a
ps
7
US
Rec
essi
on
Inter
natio
nal
Rec
essi
Some other key effects – un-antecipated
• A major crisis of confidence melting the intermediate markets
• Substantive de-leveraging aggravating the lack of credit
• The disappearance of the large US investment houses in the
form we know them
Effects on the six waves
1. Sub prime Derivative Instruments
o
o
Increased liquidity from the sub prime lead to derivatives
Credit-default swaps are derivatives, meaning they're financial contracts
that don't contain any actual assets. Their value is based on the worth of
underlying loans and bonds.
2. Derivative Instruments Hedges & Private Equity
o
``I think there's a major risk of counterparty default from hedge funds,''
Cicione says. ``It's inconceivable that the Fed or any central bank will
bail out the hedge funds. If you have a systemic crisis in the hedge fund
industry, then of course their banks will take the hit.''
3. Hedges & Private Equity Swaps
o
o
Investors can't tell whether the people selling the swaps - - known as
counterparties -- have the money to honor their promises
Combination of absolute fear and investors really not knowing
Effects on the six waves (2)
1.Swaps US Recession
With the deepening of operational financial problems, bonds default, and
swap obligations become due
5) US Recession International Recession
The interconnectivity of markets, a basis for their increased efficiency,
becomes a compounding / accelerating factor
6) Derivative Instruments Swaps
There is no real regulation in swaps and their trading creating a shadow
market that is larger than regulated markets
Effects on the six waves (3)
1.Swaps Sub prime (encompassing intermediate waves)
Billionaire investor George Soros says a chain reaction of failures in
the swaps market could trigger the next global financial crisis.
o The market is unregulated, and there are no public records showing
whether sellers have the assets to pay out if a bond defaults. This socalled counterparty risk is a ticking time bomb.
o On May 8, American International Group Inc. wrote down $9.1 billion
on the value of its CDS holdings. The world's largest insurer by
assets sold credit protection on CDOs that declined in value. In 2007,
New York-based AIG reported $11.5 billion in writedowns on CDO
credit default swaps.
2. US Recession Sub prime (encompassing intermediate waves)
o
How can CA and/or CM help?
• A forward looking environment
o
o
o
o
Monitoring companies close to real time will allow for identifying and
preventing potential issues (i.e. defaults in sub prime)
Analyze schema of debt and understand the impact with income and
mortgage terms to determine predictors
Use of analytic continuity equations to create linkage
Publish process relationships and forward looking metrics
• Transparent monitoring can create additional instability in the
markets
o
o
o
Alike fair value regulations can be blamed for increased instabilities
But will reduce counterparty opacity
Necessary for long term regulation and stability
Perverse incentives
• Loan originators and loan carriers
o
o
Praying on uneducated consumers
Too complex titles
• Rating agencies
o
Being paid by the rated entities
• Accounting rules
o
o
o
o
o
Allowing again “off balance sheet entities”
Fair value valuations precipitating unintended consequences … a
cooling period with double reporting would help
Clueless in non regulated markets
Clueless in dealing with regulated interfacing with unregulated parties
Clueless in general ☺ ☺ ☺ ☺
Markets Disappearing
• The credit crisis has choked off many of the markets that banks in recent
years relied on to take assets off their balance sheets. Issuance of
mortgage-backed securities has dropped sharply, while demand for more
complex instruments such as collateralised debt obligations – packages of
loans that have been sliced to create new securities – has dried up
completely. Many bankers think it will be months, if not years, before they
can start issuing these securities again. If and when they do, investors are
bound to demand higher returns than before and are likely to require banks
to demonstrate confidence in the securities by keeping a greater proportion
themselves.
• In short, this means that banks will be forced to fund more of their future
loans from their own balance sheet resources.
3. Monitoring financial institutions
Are the raters reliable monitors?
• Standard & Poor’s to revamp its governance procedures,
analytics and ratings transparency mark the latest in a series of
mea culpas from the leading credit rating agencies as they
attempt to restore their credibility with investors.
• Moody’s, Fitch and S&P have in recent months come under
intense fire from investors and regulators in the US and Europe
after complex structured finance instruments they rated have
suffered losses far in excess of the rating agencies’ initial
expectations.
Is the government a reliable monitor?
• The government has stayed largely in the sidelines watching
the financial bubble grow
• The regulator umbrella is cumbersome, prone to political
intervention, and lacks effective weapons to deal with the
powerful banking establishment
• Since the deconstruction of the Glass Seagall act banks have
become investment banks and vice-versa. Hedge funds and
private equity have taken secondary and tertiary roles in this
process.
Are auditors reliable monitors?
• External audit methodology is anachronistic
o
o
o
o
o
The point-in-time audit is not designed to
Monitor fast moving financial operations
Detect going concern weaknesses in short periods of times
Measure integrated risk faced by financial institutions
Deal with the fuzzy boundary issues of interlinked financial agents
• Internal audit groups
o
o
o
Are better positioned to deal with these issues
Do not have the monitoring and control charter
Need to develop a comfort zone for monitoring and assurance functions
to be negotiated among the Basel II, compliance, fraud, Sarbanes, and
operating groups
4. A proposed solution methodology
1. Database to database confirmations
3. library of
derivative
valuation programs
Counterparty 1
4. high level set
of risk KPI
and monitoring
alarming
5. Analytic
continuity equations
2. A reporting
level
controlFI
panel
enters
in thousands
of
Derivative transactions
6.
alarming/management
methodology
Counterparty n
•
•
•
•
Many transactions are multiparty
Similar instruments are actual different
There are tight and loose hedges
Catastrophic changes in markets are of dubious
headgeability
A proposed approach
• A library of derivative valuation programs drawn from various
sources, both external and internally developed.
• A template for a linkage methodology where related derivative
instruments part of a coordinated hedge will be linked
• A high level set of risk KPI and monitoring alarming features
• A reporting level control panel in addition to other alternate
views.
• An initial taxonomy of instruments, valuation measurements,
and controls
• A set of analytic continuity equations linking: varied outside
market conditions; clearance agents; derivative instrument and
security positions, and different views of risk exposures
A proposed approach (2)
• A representation of clearance agents, clients, other paper
issuers, SPEs, and other relevant entities
• A representation/experimentation in the concept of confirmatory
extranets in the validation of the existence of tertiary
transactions and of “ownership” of particular securities
• An alarming/management methodology to mitigate the danger
of rogue trading and unbalanced derivative positions
• Simulation of several alternate conditions/contingencies based
on published reports of recent frauds at Societe Generale,
Citigroup, Barings and so on to test the validity of the proposed
approach as a preventive and detective control.
5. Issues for research
Outcomes
• The result is that a banking industry has turned out to be supporting
a much larger asset base
• To make matters worse, the previously hidden assets are often those
whose value is the most suspect.
• The financial system has become leveraged to a greater extent than
one could have guessed
• The government intervention in Bear creates an immense moral
hazard problem / Lehman’s failure a serious mistake
• The injection of resources in the system and drastic reduction of the
interest rate create the danger of long term inflation / short term
deflation and the roots for the next financial bubble
• We may be nearing limits on the ability of the US government to
borrow
• A New Deal II program unavoidable
Research questions
• Can a technologically based solution and new audit
methodologies be derived to deal with or mitigate these
problems?
• How good are the current risk management platforms at the
financial institutions?
• Can a platform just involving one institution without spanning its
counterparties be relied upon?
• How to reduce the moral hazard of greedy bankers and traders
where society will finish up paying?
• While regulators diddle with the desirability of XBRL the
question that looms is if version 2.1 is adequate to represent
fast moving instruments or new XML extension languages have
to be created to deal with the “live financial report”