Out of the comfort zone

Operational risk managers are often conditioned to expect the unexpected. But recent events have sprung surprises to such an extent that many are struggling to make sense of it all. Duncan Wood looks at the human impact of the financial crisis

The credit crisis has a public face: depositors queuing outside banks, sombre finance officials on the evening news, tumbling equity markets and traders with their heads in their hands. It seems to be all about market, credit and liquidity risks. But behind the scenes, operational risks are piling up, too. Market infrastructure and back offices are being tested as trading volumes spike; legal liabilities are piling up that will be resolved in the coming years; and some banks face tough integration challenges after being forced into marriages of convenience.

For an experienced op risk manager, these are familiar tests in terms of market mechanics. But op risk is also about people, and there is a growing human dimension to the crisis, the impact of which may prove tough to understand and manage. Until relatively recently, market participants have been able to kid themselves that, however unpleasant the crisis had been, the industry would come through it chastened but essentially unchanged. Since the collapse of Lehman Brothers and the bailout of AIG in mid-September, this confidence seems to have evaporated.

"There is a real sense of exhaustion and defeatism," says Penny Cagan, managing director at risk management software supplier Algorithmics in New York. "People are demoralised and don't know what to expect." She sees as particularly alarming the speed with which the financial system has unravelled. "We have all lived through various downturns, but the pace of events this time is so quick," says Cagan. "We've had a whole series of Monday morning surprises recently, in which another bank was in trouble or another bailout was on the cards. Until we can have confidence that these surprises are behind us, a certain amount of edginess is going to remain."

That is true for the derivatives markets, but the same dynamic can be seen all over the financial system. John Trundle, chief risk officer at securities settlement agent Euroclear in Brussels, says that in the days after Lehman Brothers was declared bankrupt, his firm was inundated with requests for information from clients about their trades with the bank. The primary source of information should have been PricewaterhouseCoopers, the appointed administrator for Lehman Brothers, but the demand for information was overwhelming, so some of the firm's counterparties called Euroclear.

"They wanted to know what was going to happen to their outstanding transactions with Lehman," says Trundle. "Could they settle them? If they had collateral from Lehman, they wanted to check its precise nature, and they wanted our estimates of its value. Our people had to put in some very long hours working with clients."

Another frantic episode followed the banning of short-selling by regulators on both sides of the Atlantic, which was announced by the UK's Financial Services Authority on September 18 and by the US' Securities and Exchange Commission a day later. On this occasion, the market's efficiency was its own worst enemy. Many trading operations have automated short-selling algorithms embedded in their systems, designed to react immediately to market movements without the need for human intervention. Algorithmics' Cagan says banks faced a race against time to disable those algorithms before trading resumed the day after the ban had been announced. Staff rushed around empty trading floors in the small hours of the morning, trying to switch off all the automated commands.

One of the biggest additional burdens the crisis has imposed is on banks that have been acquirers. JP Morgan has swallowed up Washington Mutual and Bear Stearns; Bank of America now owns Merrill Lynch; Lloyds TSB has acquired HBOS; and Barclays and Nomura bought parts of Lehman Brothers. Each now has to integrate the new operations into their systems, and in the current environment, that is a massive strain.

"Everything about this is magnified exponentially now," says Jim Heinzman, securities markets managing director at enterprise-wide software supplier Actimize in New York. "These mergers create significant distractions for senior management - often, they're acquiring a business they do not already have, so they do not fully understand the nuances of the newly acquired franchise."

The initial stage of the integration will be a learning process, says Heinzman, as the acquirer tries to work out which business lines and products will be kept; which will be cast aside; and which will need to be changed. Those early, strategic decisions then give rise to webs of inter-related practical problems. "We're talking about large global public companies here, which have to comply with many layers of regulatory reporting, supervision and record-keeping," says Heinzman. "Many of the systems they are integrating have specific regulatory requirements. Some will be home-grown or built on old technology, or will lack documentation. You might want to retire a certain system but find a number of other mission-critical systems depend on it to function properly."

All this would be hard enough even without the attendant cultural and human issues, he adds. The new entity will inevitably lay off some staff. It will need to re-arrange reporting lines and juggle management assignments. "When mergers happen, employees on both sides are stressed and uncertain about keeping their jobs," says Heinzman. "There's a lot of posturing and political skirmishes, as each group tries to retain influence and access to senior management."

At the same time, staff at the acquired bank may have to abandon their old way of doing things to conform with a different corporate culture. "Firms such as Bear Stearns and Lehman Brothers were fiercely independent and had very strong cultures that are very different to those of JP Morgan and Barclays," he adds. "There's going to be a lot of emotional attachment to the fallen firm's culture, and that will not change easily."

Op risk managers must also address legal risk. The credit crisis has produced many grievances: homeowners claiming their loans were abusive; investors in securitised credit who argue the products were mis-sold; shareholders and creditors of bankrupt companies who say they were misled. Class action lawsuits have begun to pile up but will take years to conclude.

Some of the lawsuits filed post-Enron are still to be fully resolved, nearly seven years after the Houston-based energy trader collapsed, says Ken Swenson, principal at consultancy CRA International in Chicago. Banks won't know for some time what kind of legal bill the credit crisis will leave them with - if any - but op risk managers know capital needs to be set aside against these liabilities. As such, Swenson argues, they should be sitting down with the legal department now to get some sense of the exposure.

They won't be completely in the dark, says Algorithmics' Cagan. As a yardstick, she says, firms can look to the claims and settlements associated with events such as Enron and other market episodes. "Basically, investors want to be made whole, so they'll be going after banks to the extent that they perceive them to have played a part in this," says Cagan. "With Enron, for example, they went after the company's debt underwriters. If it was a $100 million bond, and you underwrote 20% of it, you'd get hit with a claim for $20 million."

On top of the unanticipated burdens the crisis has imposed, a few anticipated risks have not materialised. The credit derivatives market, for example, was an operational trouble spot before the crisis, with regulators incensed at the big default swap dealers for allowing confirmation backlogs to build up as market volumes rocketed in the past few years. The industry had responded with a remedial programme to automate more of the market's trading and processing activities - for example, switching from bilateral emails when novating a trade from one counterparty to another, and building a central repository of trade data at the Depository Trust & Clearing Corporation in New York. These relatively immature mechanisms seem to have helped the market operate fairly smoothly during the crisis.

"Around last August, we did see a spike in volume that had a knock-on effect on outstanding confirmations, but it was a short-term phenomenon," says Julian Day, head of trading infrastructure at the International Swaps and Derivatives Association in London. "They were rapidly dealt with and brought back to the normal standards." He adds that there are no reports of firms experiencing increased losses associated with operational failures.

Andreas Jobst, an economist in the monetary and capital markets department of the International Monetary Fund (IMF) in Washington, says confirmation backlogs are not the issue any more. Instead, he points to the chains of transactions that have been allowed to build up, in which risk is sequentially hedged from one dealer to the next, making the market larger and more unwieldy than it needs to be. Attempts have been made - notably by Stockholm-based swap-termination service TriOptima - to collapse these chains by tearing up offsetting trades, but Jobst says the market will still struggle to digest Lehman Brothers' collapse.

"If you do a very crude, back-of-the-envelope calculation, Lehman is one of the 10 dealers that stand behind 88% of all outstanding default swaps," he says. "(This is) a market that totals roughly $70 trillion, meaning we could assume Lehman is a counterparty to somewhere between $5 trillion and $6 trillion of outstanding swaps. In a single year, service TriOptima had been able to tear up $18 trillion in outstanding bilateral contracts, so that suggests that closing out and settling all the Lehman trades might take three months - and that's if everyone is focused on that and nothing else."

Op risk managers might find it hard to imagine having only a single issue to focus on right now and also tough to get things done, with the spotlight on credit and liquidity risks. Algorithmics' Cagan says the answer is to become a generalist. "Now is not the time to be in silos," she says. "It's not the time to go to management and talk about your capital models. People are focused on credit and liquidity risk, so that's where op risk needs to be looking to add value."

Euroclear: settling the chaos with scenario analysis

At the start of July, crisis response teams at securities settlement system Euroclear ran through a scenario exercise designed to test the settlement agent's resilience to the unexpected failure of a large bank. Ten weeks later, the exercise became a reality when Lehman Brothers collapsed. Most of the market was stunned, but Euroclear was less stunned than most.

"The shock factor was contained because we'd been through the exercise," says Euroclear's chief risk officer, John Trundle. "It helps to have thought about what your options are, so you can make decisions quickly."

One of the first decisions Euroclear had to make was whether to immediately eliminate its credit exposure to Lehman Brothers by selling off the securities it held as collateral. Trundle says the decision hinged on whether the bank's administrators wanted to run the firm as a going concern. "Our first instinct would have been to support that, because we are well-positioned to both protect ourselves and help the client," he says. "But as soon as it became clear that Lehman was likely to be liquidated, we started selling down the collateral immediately."

The collateral sales began on the Monday after the bankruptcy had been announced and, for a time, Euroclear had to field questions about whether it would face any credit loss. Trundle says he was confident from the start that there was enough collateral to more than offset the bank's exposure.

That proved to be the case as the week wore on: the stock of collateral shrank as the sales went through, but the amount of exposure to Lehman Brothers was shrinking faster. "As we sold the collateral, it raised more than we had pencilled in," says Trundle. "So I felt more and more confident day after day. We ended up with a significant margin over the top and will be able to give collateral back to the administrators."

Market conditions remain far from normal, he says, but Euroclear came through a major test unscathed. "I was pleased about the way everybody fell very naturally into their own roles," adds Trundle. "They knew what they needed to do and that made it very smooth.

"As always, there are lessons both from the exercise and the reality, and they are often about getting the right information to the right people at an appropriate speed," he says. "We learned something about that from the exercise and I'm sure we got more from what has actually happened in the last few weeks."

CLS Bank: volume-planning boosts confidence

Foreign exchange markets have seen record volumes traded during the crisis. For most institutions, volumes alone are an irrelevance - they care about price movements instead - but for CLS Bank, which settles more than half the world's forex payments, the amount of trading is critical. The company simply can't allow itself to be overwhelmed.

"Volume planning is a critical and core function within the firm for the central reason that we cannot close up shop halfway through a day," says Jonathan Butterfield, executive vice-president of marketing and communication at CLS Bank in London. "This is a 24-hour business. When Tokyo is open, New York is closed and vice versa, so there is trading going on around the clock."

The crisis saw its first major forex volume spike in August 2007, when CLS Bank settled a record 873,430 payment instructions with a gross value of $4.9 trillion in a single day. Since then, volume and value records have been smashed on a regular basis.

On November 13, 2007 the number of transactions topped 1 million for the first time. The gross value of trades broke the $10 trillion barrier on March 19. On September 17, CLS Bank settled more than 1.5 million payments for the first time - almost doubling the record set at the start of the crisis. That was a hectic day for the company, as it made and fielded calls to reassure customers and regulators, says Butterfield, but the service did what it was designed to do.

"Everyone wanted to know whether the system was working as normal," he says. "They were asking, 'Is it ok? The market is in turmoil, we need to know we can rely on settlement'. Because $8.6 trillion - the value we settled that day - is equal to twice the Japanese GDP. The numbers are just extraordinary."

To give the market confidence, CLS Bank has an ongoing volume-planning process - it regularly surveys its members to gauge expectations for future business, and ties this in to a programme of regular upgrades to the system, to maintain spare capacity and ensure the system can handle future spikes. The latest upgrade - the third in six years - is close to completion.

"We operate most days with a lot of headroom, and we are in the process of doubling that headroom again," says Butterfield. "The project actually started at last year. The hardware upgrade is already in place and the final software changes are due before the end of the year."