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FSA insider: Blindness to risk left banks vulnerable to "open-ended" losses

Bank controls | FSA insider: Blindness to risk left banks vulnerable to Ian Fraser

The cluelessness of most banks and G-SIFIs about their own financial strength, which I touched on in my earlier blog post on systems meltdown at RBS and NatWest, was recently highlighted as the number one cause of the global financial crisis by Andy Haldane, the Bank of England's director for financial stability.

One of the main reasons for the bank's inability to know what they're actually doing or to accurately consolidate their own numbers is the shocking inadequacy of their IT systems, many of which are a patchwork of legacy systems whose cores are over 40 years old.

Other causes include the sheer size and scale of modern financial institutions, their silo-like structures, the flawed way in which they adopted IFRS accounting standards after 2005, the supinenness of "Big Four" auditors, the "capture" of financial regulators, the incompetence and self-serving nature of most banks' management, or a mixture of these and other factors.

In this blog post, however, I intend to focus on IT and structure as the main reasons for banks' cluelessness.

Banks' IT systems are both surprisingly ancient and mind-numbingly complex. Most large banks do not dare change their underlying systems because, as Chris Skinner has written, to do so is a bit like trying to change the engines on an airplane while it is flying at 40,000 feet. Instead they go for regular upgrades. Sometimes these "patches" go massively wrong, as we recently saw with the recent NatWest, Ulster Bank, and RBS fiasco.

The overall result of the banks' approach to IT is that their systems are generally incapable of giving proper visibility of the consolidated balance sheet. This creates an internal blindness to build-ups of risk which, when coupled with "fairy tale" accounting and weak risk management and compliance, opens the door to "white collar" crime and fraud.

As part of his "Banking Blog" in The Guardian, Joris Luyendijk has interviewed an anonymous Financial Services Authority insider. The 30-something FSA supervisor confirmed some of the above. He said:

"The real threat is not a bank's management hiding things from us: it's the management not knowing themselves what the risks are, either because nobody realises it or because some people are keeping it from their bosses."

He said this ensures that when new products that blow up in consumers' faces are developed, the people who devised them usually go unpunished.

"Why aren't more people going after the designers of those complex financial products, the structurers and product management people? They got it past their internal risk and compliance people by presenting them with a sanitised version of whatever they had built, rounding off the risky edges and making it seem simpler and safer than it is. Then these risk and compliance people present it to us.

"The only way to reduce risk is to increase transparency. Without that, the real risks will remain bubbling under the surface. Is the sector fixed, after the crisis? I don't think so. As you saw with the JP Morgan loss recently, there's always a degree of inherent risk.

Overall the FSA supervisor argued that the global financial crisis was "more cock-up than conspiracy" and accused banks' management of pursuing strategies that are best for their short-term careers or bonuses, rather than thinking about what might be in the long-term interests of the bank or the country: "People are not managing their bank: they are managing their careers." (Since the Luyendijk interview, the LIBOR rigging scandal has erupted to cast serious doubt on his claim).

The FSA insider said that the next "black swan" event is likely to come from the enormous derivatives market.

"That remains a big problem. No one knows the liabilities with derivatives. When they 'go against you' and you start losing lots of money, you can't just unwind them and close the position by selling, because nobody will want them. Derivatives often have high levels of complexity, meaning you need time to work out what they're worth. Time adds more risk ... [The] potential for losses is almost open-ended.

Given the potential losses that many of the world's largest banks now face (both in terms of civil and criminal penalties, and in civil damages claims) from their concerted attempts to "rig" the US$360 trillion market of financial instruments that are linked to LIBOR and related interbank rates, I think his prediction may be about to come true. And yes it does look to have been a crisis of their own making.

Further reading banks' systems and controls and the LIBOR rigging scandal:

Tags: 'white collar' crime , audit , auditing , Banking Blog , compliance , derivatives , Financial Services Authority (FSA) , fraud , FSA , information technology , interbank funding , internal auditing , Joris Luyendijk , Libor , risk , systems , The Guardian
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