The Need for Continuous Monitoring and Assurance of Financial Transactions.

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The Need for Continuous Monitoring and Assurance
of Financial Transactions.

• Miklos A. Vasarhelyi KPMG Professor of AIS,
  Rutgers Business School, Technical Lead, ATT
  Laboratories
• Michael Alles, Associate Professor, Rutgers
  Business School
• Alexander Kogan, Professor, Rutgers Business
  School

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Outline

1. Why dont we learn?
2. The anatomy of a crisis
3. Monitoring financial institutions
4. A proposed solution methodology
5. Issues for research

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1. Why dont we learn?
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Why dont 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
  Feds 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. Greenspans interest lowering

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Why dont 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
• the nearly totally unregulated nature of hedge
  funds
• the immense greed of both LTCM partners and their
  counterparties
• the lack of disclosures on derivatives by all
  parties

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Why dont we learn? (3)

• Since those days (10th Year anniversary
  celebration of LTCM)
• 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

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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.
  

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2. The anatomy of a crisis
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Six waves
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6
5
2
4
1
3
Sub prime
Derivative Instruments
Hedges Private Equity
Swaps
US Recession
International Recession
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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

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Effects on the six waves

• Sub prime Derivative Instruments
• 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.
• Derivative Instruments Hedges Private
  Equity
• 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.''
• Hedges Private Equity Swaps
• 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

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Effects on the six waves (2)

• 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

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Effects on the six waves (3)

• 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.
• The market is unregulated, and there are no
  public records showing whether sellers have the
  assets to pay out if a bond defaults. This
  so-called counterparty risk is a ticking time
  bomb.
• 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.
• US Recession Sub prime (encompassing
  intermediate waves)

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How can CA and/or CM help?

• A forward looking environment
• 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
• Alike fair value regulations can be blamed for
  increased instabilities
• But will reduce counterparty opacity
• Necessary for long term regulation and stability

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Perverse incentives

• Loan originators and loan carriers
• Praying on uneducated consumers
• Too complex titles
• Rating agencies
• Being paid by the rated entities
• Accounting rules
• 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 ? ? ? ?

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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.

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3. Monitoring financial institutions
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Are the raters reliable monitors?

• Standard Poors 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.
• Moodys, Fitch and SP 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.

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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.

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Are auditors reliable monitors?

• External audit methodology is anachronistic
• 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
• 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

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4. A proposed solution methodology
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1. Database to database confirmations

Counterparty 1
4. high level set of risk KPI and monitoring
alarming
3. library of derivative valuation programs
5. Analytic continuity equations
2. A reporting level control panel
FI 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

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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

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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.

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5. Issues for research
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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 / Lehmans 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

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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