Paradigm shifts exist in all walks of life and of business, not just in technology and in banking. Take as an example Michelin’s active wheelwhich is fitted to the front of the vehicle and has an integrated active suspension system, disc brake, and permanent magnet motor. The engine looks futuristic but experts say that it is:
● Only three car ‘generations’ away, and
● Well within the period covered by the industry’s most forward-thinking designers and engineers.5
In automotive engineering, the active wheel is a huge paradigm shift from the well-known pneumatic tyre, which has been around for almost as long as the motor car itself. The concept underpinning the classical type has survived even if during that time new knowledge, materials, and industry demands have dra- matically changed its characteristics and performance.
The radically new design of an integrated development of tyre and wheel chal- lenges convention with a technology that has the potential to re-write the rules of traction, stability, and comfort. It’s puncture-proof, too, says Roger Bishop, editor of European Automotive Design. Both designers and users of motor vehi- cles should take notice.
Among the interesting innovations of the active wheel is the fact that there are no mechanical connections to the energy source, allowing development engi- neers to remove a number of components including the clutch, gearbox, trans- mission, anti-roll bar and shock absorbers – which have been standards in auto design. According to Michelin, vehicles fitted with this technology will be able to maintain a stable chassis while turning, because body and wheel angles can adopt motorcycle geometries.
Let’s now carry this concept of a paradigm shift into financial analysis. An evi- dent example is the calculation of a company’s distance to defaultby proxy. The distance to default point represents the number of asset value standard deviations away from default point (DP). This distance is calculated using option pricing theory, to solve for:
● Unobservable market value of assets, with capitalization as proxy
● Volatility from observable capitalization, and
● Leverage data relative to the firm, and its ballooning liabilities.
Most evidently, the probability of default is related to the firm’s indebtedness measured by the equity to debtratio. The default point is the point at which the bank’s value is precisely equal to the value of its liabilities. This practically means its equity is zero (see also section 5). The algorithm with which the reader is already familiar, is:
1
If ⬍1, thenthe company is insolvent.
The use of capitalization as proxy in calculating default is a new departure, but at the same time it is part of the old discipline of challenging the obvious.
Another paradigm shift in finance is the ongoing trend towards abandoning the 1-year time perspective and generating a 5-year default likelihood estimation. By tying projected, further-out credit scores directly to default probabilities, it can be possible to determine over the medium term pricing milestones:
● For underwriting, and
● For securitization reasons.
The need for a further-out credit outlook for enterprises is evidenced by the fact that while consumer-lending has experienced significant transformation over the past 10 years, middle market lending is still a largely subjective process, one that concentrates on the short term.
The point is that the use of short timeframes for multi-year commitments is no longer admissible at a time of deregulation, globalization, and increasing num- ber and size of risks, some of which may be latent but turn around and hit the creditor some years later. Their unearthing requires the paradigm shift of which we spoke earlier in this section.
Look again at Michelin’s active wheel as an example that can provide guidance on how to steer away from old concepts. The new design replaces the tyre and wheel with a composite reinforced tread band, connected to a wheel that is both flexible and deformable through rectangular polyurethane spokes. This structure has the weight-carrying ability, shock absorption, ride comfort and rolling resist- ance characteristics of a pneumatic tyre. It also features suspension-like proper- ties that are said to greatly improve handling. That is the sort of composite measure that can help to significantly improve upon the current ways and means to which we have become accustomed, but which may well be obsolete.
ᎏAL
Capitalization ᎏᎏLiabilities ᎏAL
As far as Basel II is concerned, the use testmay be a catalyst in the direction I am suggesting. The April 2005 consultative document to which reference was made in section 7 has this to say on use tests: the distribution of exposures generated by the internal model for computation of effective expected positive exposure (EPE) must be closely integrated into the day-to-day counterparty credit risk (CCR) management. The bank could use:
● Peak exposure from the distributions for counterparty credit limits, or
● Expected positive exposure for its internal model for capital allocation.
The internal model’s output should play an essential role in credit approval, as well as credit risk management, and corporate governance at large. Notice that use tests have a double meaning. On the one hand, is that results provided by the implementation of Basel II rules and models should be used in decision-making.
On the other, is senior management’s participation in implementation of Basel II, including analysis of obtained results. This, too, is a paradigm shift as far as top executives are concerned.
Notes
1 Nancy Cartwright, How the Laws of Physics Lie, Oxford University Press, Oxford, 1983.
2 D.N. Chorafas, Rocket Scientists in Banking, Lafferty Publications, London and Dublin, 1995.
3 D.N. Chorafas, The Real-Time Enterprise, Auerbach, New York, 2005.
4 Basel Committee, ‘The Application of Basel II to Trading Activities and the Treatment of Double Default Effects’, a Consultative Document, BIS, Basel, April 2005.
5 European Automotive Design, February 2005.
16
Internal Control, Stress Testing, and Effective Risk Management
1. Introduction
The design of an internal control system starts with a definition of goals: What exactly are we after in terms of good governance? At which level of transparency do we want the internal control system to operate? How capillary should it be?
What do we wish to accomplish? At what level of timeliness and dependability?
The next step includes identification of the sources of information that should contribute to internal control. This should be followed by:
● Evaluation of current internal control policies and practices, and
● An examination of the reliability of the existing internal control system.
For internal control to work correctly, it is important that there is no covering-up of problems by ‘this’ or ‘that’ manager, at any level of the organization. IFRS con- tributes a great deal to the mechanics part of internal control by promoting trans- parency and by bringing fair value into perspective. But top management must also play its part by:
● Assuring the dynamics of the financial reporting system, and
● Seeing to it that the organization’s arteries are not clogged through opacity, indifference, inability, or conflicts of interest.
Internal control works well only when decisions, actions, and results obtained by all managers, at every business unit, are characterized by openness, objec- tivity, and transparency in appraising their own performance and that of others.
Everything counted, this is the simple, most valuable index of management’s strength.
Take risk management as an example. No effective risk evaluation process can take place without identification of all relevant sources of risk information, and of their accuracy. The preliminary work includes the definition of risk sources, followed by risk limits, risk models and rules associated to credit, market, and operational information. Another ‘must’ is the examination of facilities used to:
● Perform risk analysis, and
● Exercise control over the entire organization.
Enterprise-wide risk management brings to the foreground the need for a con- ceptual framework based on sound management practices and rigorous internal control principles.1To avoid a fragmented approach, the design of a consolidated internal control framework must ensure that it is:
● Global in nature
● Integrating all units which organizationally or geographically may be separate
● Filtering large volumes of data with internal control objectives in mind, and
● Assuring real-time processing as well as comprehensive reporting at all management levels.
For instance, in connection to risk management, the accurate computation of exposure requires access to a wide range of databases located throughout the organization and its business units. Among other locations, information will be needed in transaction logs, legal contracts, market data feeds, trading systems, pricing models, the corporate memory facility (CMF, see Chapter 9), and back- office records.
Along with the ability to capture, integrate, filter, and report internal control information, a main challenge in an enterprise solution is that operational data provided by different units, and systems, is often rich in detail but narrow in scope. Most organizations find themselves with isolated islands of information, which may or may not have bridges to one another. Business activities are fre- quently supported by:
● Applications running on different hardware platforms and operating systems
● Information coming from many levels within the institution, often in inconsistent physical forms
● Widely spread files and databases which usually have heterogeneous record and data structures.
As we saw in Chapter 15, real-time update and reporting is another challenge. The volume of updates that will be generated depends on risk events being targeted;
when and how these are created by different trades; number of risk factors to be handled; internal structure of the institution (desk, department, business unit);
number and form of limits being updated (trading book, banking book, counter- party, country, type of trade); time-handling of required procedures, and so on.
A single trade may generate multiple updates, and each time an inventoried position is modified or priced, most or all of these updates have to be recom- puted and reapplied. They also have to be tested and this leads straight into issues connected to testing policies: normal or stress testing followed for risk management purposes. As we will see in this chapter, stress testinghas become an integral and important part of corporate governance.