Risk Management Technology in Financial Services

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Complexity of risk control with derivatives 57

bankruptcy), and the toxic waste in the derivatives portfolio of South Korean banks –

after the spectacular South Korean bankruptcy, in late 1997.

Historical statistics from the bankruptcy of the Bank of New England indicate a

demodulator of 6, and from the East Asia meltdown in 1997 – Thailand, Indonesia

and South Korea – a demodulator of 5.

Added to that is legal risk. At the time of the South Korean meltdown, a British

bank had a derivatives contract with a South Korean bank. This was a binary option

on the price of the won, specifying that the reference price will be the one published

in the daily bulletin of the South Korean National Bank.

With the country’s bankruptcy the won dived, but also the South Korean National

Bank stopped publishing its exchange rate. The South Korean counterparty of the

British bank refused to pay, saying that there was no officially published price. The

case went to court, and it stayed there for a long time.

3.7 Effective management control starts at the top

Andrew Carnegie, the late 19th century Scottish/American steel magnate, was

demanding from the general managers of his companies weekly reports on the back

of which he scribbled his comments, questions, suggestions and explosions of temper

or exasperation: ‘I think (if you will excuse me) that for the success of your admin-

istration it will be wise for you to let office work go for a while, and visit every

competing works often and get posted about their modes, costs and men. If you find

a real man anywhere get him in your service.’

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Riding horses rather than riding desks is the policy of wise CEOs; a policy that

becomes so much more urgent to establish with the concept of exposure associated

with derivative financial instruments. Effective enterprise-wide management control

starts at the top.

‘In many cases, senior management does not have a good handle on what risks are

being taken,’ Dr Henry Kaufman, the best living economist, suggested in a confer-

ence, ‘The fact is that sizeable losses have been incurred in such areas as mortgage

derivatives, even by well-run institutions.’

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Moreover, in a speech to US Securities

Association, November 1992, the president of an investment bank said: ‘Bad risk

management could sink a firm in 24 hours.’

Lack of transparency in many derivatives deals has rendered the nature of risks,

and their distribution, greatly different to what schools of finance have been clas-

sically teaching. Many exposures are much more invisible than they used to be,

though some visibility can be gained through worse case scenarios and by means of

experimentation, provided that banks don’t confuse:



Worse case scenarios, which aim to explore extreme but plausible conditions, and



Nightmare scenarios which, if and when realized, may signal the end of the financial

institution.

Many knowledgeable people at senior management positions have volunteered

advice on the risks embedded in derivatives: The growth and complexity of off-

balance sheet activities and the nature of credit, price and settlement risk they entail