human resource management in financial services · pdf filemanagement and organisation in...

Management and Organisation in Financial Services September 11, 2009

Ee Suen Zheng

Management and Organisation in Financial Services

When trading becomes gambling

Executive Summary

When trading for a firm’s own account becomes a

major activity, it ceases to be ‘trading’ and becomes

‘gambling’ (Peter Drucker, 2002). This rings true to the

banking industry from the various dramatically seen

examples like the recent subprime crisis which has affected

even banking behemoths like Citigroup, UBS and Bear

Sterns. The lack of control and regulations in the banking

industry make it seem as though these ‘investment banking’

activities run parallel to the trading and speculating done by

hedge funds. What concerns the public and various

corporations with huge stakes in these ‘super regional’

banks, is whether their interest in being safeguarded or

neglected as profits from ‘trading’ seem to be more

important than the risk of ‘trading’ for these financial

institutions.

Working Paper

Sheffield Business

School

At Sheffield Hallam

University

Ee Suen Zheng

Bachelor of Arts with First Class

Honours in Banking and Finance

+603-9283 8950

+6016-696 6566

[email protected]

jamesesz.wordpress.com


Ee Suen Zheng

Executive Summary

When trading for a firm‟s own account becomes a major activity, it ceases to be

„trading‟ and becomes „gambling‟ (Peter Drucker, 2002). This rings true to the banking

industry from the various dramatically seen examples like the recent subprime crisis which

has affected even banking behemoths like Citigroup, UBS and Bear Sterns. The lack of

control and regulations in the banking industry make it seem as though these „investment

banking‟ activities run parallel to the trading and speculating done by hedge funds. What

concerns the public and various corporations with huge stakes in these „super regional‟ banks,

is whether their interest in being safeguarded or neglected as profits from „trading‟ seem to be

more important than the risk of „trading‟ for these financial institutions.

Question a)

Leading money center banksi have accelerated their investment banking activities

especially in the trading of debt securities and stocks in the secondary market as they struggle

to compete against other money center banks and smaller community banksii across the globe

(Peter Rose & Sylvia Hudgins, 2008). By purchasing corporate debt securities and stocks and

reselling them, these banks aim on acquiring higher profits as shown in figure 3iii

. Banks that

invest in debt securities such as bonds and loans can earn interest on it according to the

creditworthiness of borrowers (low credit ratings require a higher risk premium). Besides

that, banks may also acquire fee income through servicing debt securities that are securitized,

security underwriting, and brokerage services.

To research these issues, we would use historical investment banking activities and also

the recent subprime crisis to understand the relationship between risk and return while at the

same time studying the effects of investment banking activities in terms of its profits, risk and

from the public perspective. Investment banking activities, especially the trading of debt


Ee Suen Zheng

securities and stocks is seen to be highly profitable in the pastiv

. This is shown through the

historical data of Long-Term Capital Management (hedge fund) that boasted an annual return

of 40% in its early years and also two hedge funds under Bear Sterns, an 84 year old

investment bank that also gained double digit returns before their downfall.v

Recently, debt securities have changed hands in an increasing active secondary market

(Anthony Saunders & Marcia Million Cornett, 2006). The banks transfers the ownership of

the loans to other investors that are willing to absorb the risks to earn profits in a process we

now call securitizationvi

. Moreover, any fee income earned under such buying and selling can

be recognized as current income and also an off-balance-sheet activity compared to the

interest earned on direct lending that is accrued over time (Anthony Saunders & Marcia

Million Cornett, 2006). Other trading activities by banks aim at capital gains by holding long

positions in debt securities and stocks for an extended amount of time with the bank‟s excess

reserves.

However, higher returns come with a tradeoff of higher riskvii

. Investment banking

activities contains both systematic and unsystematic risks. The types of risk involve include

credit, liquidity, operational, reputation, capital, prepayment, call, and business risk.viii

These

types of risk are commonly seen in the debt security and stock markets. As an example,

investing in risky corporate bonds expose the banks to credit, capital, prepayment, call, and

business risk. Furthermore, by holding on to debt securities and stocks, the banks are

exposing themselves further to market risk or systematic risk which cannot be eliminated

through the diversification of assets.ixx

To make matters worst, most money center banks are

also involve in securitization whereby loans of different quality (like home mortgages and

credit card receivables) are group together and sold to other parties willing the accept the risk

(Peter Rose & Sylvia Hudgins, 2008). Securitization increases the chances of the approval of

subprime loans while exposing certain parties to high risk without them realizing it.


Ee Suen Zheng

From the public point of view, a bank‟s main purpose is to make loans to businesses and

individuals and not to buy and sell debt securities and stocks. The trading of debt securities

and stocks enhances the probability of moral hazard problems which is commonly

highlighted in agency theory. The moral hazard problem occurs when the lender (depositor)

runs the risk that the borrower (bank) will engage in activities that are undesirable from the

lender‟s point of view (Mishkin, 2007). In this case, the bank‟s investment in risky debt

security and stocks causes a moral hazard problem as it damages the bank‟s ability to repay

depositors should their investment plan fails. Furthermore, bank managers acting as an agent

has an incentive to engage the bank in risky activities as the losses would be absorbed by the

depositors and gains would be credited to their name.

Question b)

A corporation placing large deposits with a bank engaged in such activities would be

very concerned about its funds. First, trading debt securities and stocks exposes the bank to

not only non-systematic risk, but also systematic risks. Non-systematic risks can be avoided

through proper diversification of financial assets and other risk management methodsxi.

However, systematic risk or market risk cannot be eliminated this way and thereby exist in

the entire financial market. Should a financial crisis happen, banks holding illiquid financial

assets such as corporate bonds, stocks, and securitized assets like collateral debt obligations

(CDOs) and collateral loan obligations (CLOs) will find themselves facing a severe liquidity

crisis.

Recent deregulation of the banking and finance industry has not helped to safeguard

depositor interest. Further adding to the problem is the breakdown if the Glass Steagall Act in

1999 that used to separate commercial banking activities and investment banking activities

(Stephen Cecchetti, 2006). Through many mergers and acquisition like those of Citicorp and

Travelers Group, money center banks have emerged and are quickly developing their own


Ee Suen Zheng

investment arm. Lack of regulation in investment banking activities have also gave money

center banks a free hand in conducting trading and speculating of risky debt securities and

stocks without getting into trouble from authorities. One of the recent cases in trading

scandals by banks were that of Nick Leeson who speculated on the Nikkei in 1992 and in a

matter of 3 years garnered $1.3 billion of loses for Barings Bank (Frederic Mishkin, 2007).

Besides that, the wide span of control and complexity of money center banks makes their

management a problem (Peter Rose & Sylvia Hudgins, 2008). The span of control determines

how closely a supervisor can monitor subordinates (Richard L. Daft, 2008). Money center

banks have more hierarchical levels and a wide span compared to smaller community banks.

This adds problems to management as top managers are often disconnected from

subordinates in lower levels. Furthermore, financial globalization have also brought further

complexity to money center banks as they are not centralized in one country but are often

scattered across the globe.

Another concern would be of the principal-agent problem which occurs when the

managers in control act for their own interest instead of the interest of stockholders and

stakeholders. A clear example of this would be Ralph R. Cioffi who managed two Bear

Sterns hedge funds. Driven by the incentive of getting his performance fees, Cioffi used

aggressive and highly risky investment strategies to boost return (Matthew Goldstein &

David Henry, 2007). By dumping most of the hedge fund‟s money into the CDO market,

leveraging money to the maximum, and also neglecting his reserves, Cioffi basically signed

the death sentence of the two hedge funds in his management while at the same time

tarnishing the reputation of Bear Sterns.

The risk facing money center banks is very real even though their size, net worth, and

global presence seems to provide them security and strength. However, almost every big

financial firm has now reported substantial „trading losses‟ (Peter Drucker, 2002). In some


Ee Suen Zheng

scenarios, these „trading losses‟ have been heavy enough to kill the bank. From British

Barings to New York‟s Bankers Trust to Japan‟s Sumitomo, we can see that trading and

speculating involves high risk that will from time to time strike down another victim.

Question c)

Having known the various risk and possible scenarios of the trading and speculating done

by money centre banks, our mind now run through the possible solutions in management that

can be used to safeguard and govern funds managed by these financial institution. George

Benston contends that financial-service institutions should be regulated. Hence, there is a

need of strong regulations to safeguard the funds. Regulations should call for more

transparency not only from banks but also from the bank‟s customers. An example of this

would be the Sarbanes-Oxley Act of 2002 that was established to regulate public accounting

firms that audit publicly traded companies (Peter Rose & Sylvia Hudgins, 2008). The

Sarbanes-Oxley Act basically calls for more corporate governance which is desperately

needed in the industry. However, regulations do not prevent bank failures (S. Scott

MacDonald and Timothy W. Koch, 2006). Regulations are unable to eliminate all risks from

the entire system and it only serves as a guideline for banking operations which acts as

external controls.

Another method to safeguard funds in banks dealing with investment banking

activities is to diversify its portfolio of assets. Money center banks need to invest more in

government bonds such as the US treasury bonds to diversify its portfolio into a more

diversified risks distribution as government bonds are safer than corporate bonds. If the

portfolio is well diversified, the funds tend to be less risky. A well diversified portfolio

should contain assets that are low or negatively correlated. However, in the world of reality, it

is hard to pool such assets into a bank‟s portfolio. One way to solve this would be to use


Ee Suen Zheng

international portfolio diversification whereby the money center bank holds internationally

issued financial instruments. It is not uncommon for an Asian economic expansion to take

place in the midst of a US recession. However holding international portfolios will still

subject banks to systematic risk.

Information technology should also be used to strengthen the links of communications

in money center banks. Because of the wide span of control and decentralized geographical

locations of these gigantic institutions, information technology can play an important role in

their management. Information systems like Enterprise Resource Planning (ERP) can solve

the problems of outdated and redundant information by collecting data from various

departments and storing them in a single central data repository (Kenneth C. Laudon and Jane

P. Laudon, 2007). Accurate and real-time information of trading activities can help top

management to fully judge their risk positions and enable quick responses should there be

any mismanagement of funds.

Lastly, management incentives should be carefully implemented so as to reduce the

seriousness of the conflicts of interest in agency theory. Performance fees, bonuses, and

commissions should be judged based on management prudence and performance instead of

how much money a certain individual has earned for the company. According to Peter

Drucker (2002), top management seems to have carefully looked the other way as long as

trading produced profits and until losses becomes so big that they could no longer be hidden,

the gambling trader was a hero and is showered with money. This greatly encourages risk

taking and must be avoided so as to fulfill the bank‟s fiduciary responsibility to their

stakeholders.


Ee Suen Zheng

Conclusion

Richard Dennis, one of the legendary commodity traders of our time once said that

95% of his profits have come from only 5% of his trades (Jack Schwager, 1989). The odds of

money center banks in the secondary markets may also seem to be similar to those of the

commodity markets. Money center banks should not make trading is major activity and

turning „trading‟ into „gambling‟. For no matter how clever the gambler, the laws of

probability guarantee that he will eventually lose all he has gained, and a good deal more

(Peter Drucker, 2002). Instead, the top management of money center banks should closely

monitor and screen investment activities and continue to emphasize on risk management.

References

Anthony Saunders & Marcia Million Cornett (2006), Financial Institutions

Management: A Risk Management Approach, 5 th edition, Mc Graw Hill (p.790,

p.801)

Daft Richard L. (2008), New Era of Management, 2nd edition, US: Thomson South-

Western. ( p.311)

Jack Schwager (1989), Market Wizards: Interview with Top Traders, New York

Institute of Finance. (p.115-116)

Kenneth C. Laudon and Jane P. Laudon (2007), Management Information Systems,9th

edition, Prentice Hall. (p.61-62, 386)

MacDonald. S. Scott & Koch. Timothy W. (2006), Management of Banking, 6th

edition, US: Thomson South-Western. ( p.28)


Ee Suen Zheng

Mishkin, Frederic S. (2007), The Economics of Money, Banking, and Financial

Markets, 8th

edition, Boston: Pearson-Addison Wesley. (p.243, p.38)

Peter Drucker (2002), Managing in the Next Society, St. Martin‟s Press. (p.131-147)

Peter Rose & Sylvia Hudgins (2008), Bank Management & Financial Services, 7th

edition, NY: McGraw Hill. (p.5-6, 70-71, 282-284, 310)

Stephen Cecchetti (2006), Money, Banking, and Financial Markets, NY: McGraw

Hill.

Business Week, October 22, 2007: Bear Bets Wrong by Matthew Goldstein & David

Henry

Business Week, September 3, 2007: Not So SMART by Roben Farzad, Matthew

Goldstein, David Henry, Christopher Palmeri

The Economist , Democracy‟s chance in Afghanistan, October 9th

- 15nd

2004,

Hedge Funds and Private Equity: p.67

The Economist , Saving Japan From the Shadows, February 4th

- 10th2006: Banks and

Hedge Funds: p.70-71

Brigham, E (2004), Fundamentals of Financial Management, tenth edition, South-

Western.

Jones C. P. (2004), Investment Analysis and Management, 9th edition, John Wiley &

Sons, Inc.

Keith H. Black (2004), Managing a Hedge Fund: a complete guide to trading,

business strategies, operations, and regulations, The McGraw-Hill.

Prasanna Chandra (2006), Investment Analysis and Portfolio Management, 2nd

edition, Tata McGraw-Hill.

Liaw, K. Thomas (2004), Capital markets, Thomson South-Western.


Ee Suen Zheng

i Figure 1 Money Center bank – Adapted from Peter Rose and Sylvia Hudgins, 2008, p70-71


Ee Suen Zheng

ii Figure 2 Smaller Community Bank – Adapted from Peter Rose and Sylvia Hudgins, 2008, p.70-71

Senior Executive Committee

(President/CEO)

Fund Raising & Funds

Management Division

Investment and Funding Group

Portfolio Management and

Money-Market Desk

Institutional Banking

Department

Capital Markets Department

Asset/Liability Management

Planning

International Banking

Department

Global Finance

Foreign Offices Group

Funds-Allocation Division

Commercial Financial Services

Group

Commercial Credit

Commercial Real Estate

Corporate Services

Credit Cards

Loan Review Group

Loan Workout Group

Operations Department

Auditing and Control Department

Branch Office Management

Computer Systems

Human Resources

Teller Department

Securities Department

Regulatory Compliance Group

Personal Financial Services Division

Private Banking Services

Trust Services

Residential Lending

Customer Services

Safe Deposit Department

Lobby Services Group

Motor, ATM, and Internet Banking


Ee Suen Zheng

iii Figure 3 Investments: The Crossroads Account on a Depository Institutions Balance Sheet

Assets Liabilities

Cash Deposits

A ↓ ↑ B E ↓ ↑ F

Chief Administrative Officers

(Chairman/CEO)

Lending Division

Commercial Loan Officers

Consumre Loan Officers

Accounting and Operations Division

Accounting and Audit Department

Operations

(check clearing, posting, account verification, and

customer complain)

Fund-Raising and Marketing Division

Tellers

New Accounts

Advertising and Planning

Trust Division

Personal Trust

Business Trust


Ee Suen Zheng

Investments → Nondeposit Borrowings

← C ↓ ↑ D

A) Add to investments when cash is high B) Sell investments when cash is low C) Sell investments when loan demand is high D) Add to investments when loan demand is low E) When deposits are low use investments as collateral for more borrowings F) Return investments pledge as collateral to the investment portfolio when the deposit growth is high

Peter Rose & Sylvia Hudgins, 2008, p.310

iv A History of Hubris – Adapted from: Business Week, Not So Smart, 3

rd September 2007

Time Details

1980s Junk-bond king Michael Milken of Drexel Burnham Lambert, who champions the high-

yield corporate debt market and later pleads guilty to fraud, argues that the higher rates

would more than offset any potential risk to the product.

1989 After defaults unexpectedly soar, the $200 billion junk bond market collapses, exacerbating the savings and loan crisis. Lincoln S&L fails.

1994 Backed by a dream team including Nobel prizewinners Robert Merton and Myron

Scholes, Long-Term Capital Management opens, racking up annualized gains of 40% in

its early years.

1998 When LTCM‟s computer models fail to anticipate shocks like the Russian debt crisis,

the hedge fund sheds nearly $5 billion in four months, prompting the Fed to arrange a

$3.5 billion bailout.

1999 Embracing a “New Economy,” investors bid up prices on technology outfits and back

brand-new ventures with little or no earnings.

2000 The bubble burst NASDAQ falls 34% in a month, and Pets.com falls.

2004 Fed Chairman Alan Greenspan praises the virtues of adjustable-rate mortgages and

refinancing for the average homeowner.

2006 In the era of easy money, the subprime market reaches $600 billion a year, and

leveraged buyouts hit $525 billion.


Ee Suen Zheng

Present The Mortgage flu spreads, infecting the credit markets and much of wall street.

vAdapted from: Bear Bets Wrong, Business Week, 22

nd October 2007


Ee Suen Zheng

vi Figure 4 Process of Securitization

Oct 1, 2003

•Bear Sterns High-Grade hedge funds opens

Dec 31,2004

•The Funds reported a one-year gain of 16.88%

August,2006

•Bear Sterns Enhance hedge funds opens

October, 2006

•Everquest Financial, a Bear Sterns affiliate, begins buying risky pieces of collateral debt obligations from the two hedge funds

February, 2007

•Problems at New Century Financial and other lenders spark the subprime meltdown

•The manager, Ralph Cioffi, talks about a 'catharsis' in the mortgage industry

March, 2007

•The Enhanced and High-Grade funds report monthly losses of 5.41% and 3.71% respectively

•Investors start redeeming their money

May 9, 2007

•Everquest Financial files for an initial public offering

May 15, 2007

•Bear Sterns warns investors in the Enhanced fund to expect a 6.5% drop for April

June 7, 2007

•Bear Sterns revises the April decline for the Enhanced fund to 18.97% and freezes investor redemption

June 22,2007

•Bear Sterns announces a $1.6 billion loan for the High-Grade fund

June 30, 2007

•Bear Sterns halts redemption from the High-Grade fund

June 31, 2007

•The two funds file for bankruptcy


Ee Suen Zheng

vii

Tradeoff between Risk and Return

Loan Originator

Loans

Special Purpose Vehicle

Asset-backed securities

Underwriter

Institutional investors

Credit EnhancerRating Agency


Ee Suen Zheng

Taken from: Risk-Reward Tradeoff- http://www.investopedia.com/university/risk/risk3.asp

1.04 PM, 29 December 2007

viii

Figure 5 Types of Risk MacDonald. S. Scott & Koch. Timothy W. (2006)

Type of Risk Definition

Credit Risk Associated with the quality of individual assets and the likelihood

of default.

Liquidity Risk Current and potential risk to earnings and the market value of

stockholders‟ equity that results from a bank‟s inability to meet

payment or clearing obligations in a timely and cost-effective

manner.

Operational Risk The possibility that operating expenses might vary significantly

from what is expected, producing a decline in net income and firm value.

Reputation Risk The risk where negative publicity, either true or not true can

adversely affect a bank‟s customer base or bring forth costly

litigation, hence negatively affecting profitability.

Capital Risk Refers to the potential decrease in the market value of assets below

the market value of liabilities, indicating the economic net worth is

zero or less.

Prepayment Risk Risk specific to asset-backed securities because the realized interest

and principal payments from the pool of securitized assets may be

quite different from the cash flow expected originally.

Call Risk Risk of earning a loss because it must reinvest its recovered funds at

lower interest rates.

Business Risk Risk that the economy of the market area they serve may turn

down, with falling sales and rising unemployment. ix Systematic and Unsystematic Risk

http://www.investopedia.com/university/risk/risk3.asp


Ee Suen Zheng

Taken from: Risk-Reward Tradeoff- http://www.investopedia.com/university/risk/risk3.asp

1.04 PM, 29 December 2007

x Market Risk

xi Risk Management Method

Type of Risks Risk Management

Credit Risk - Perform a credit analysis on each loan request to assess a

borrower‟s capacity to repay.

- Bank investment restricted on investment-grade securities.

Liquidity Risk - Bank holding liquid assets

- Bank will secure its ability to borrow at reasonable cost.

Market Risk

Interest Rates Risk

Equity Price Risk

Foreign Exchange

Risk

Security Price Risk

http://www.investopedia.com/university/risk/risk3.asp


Ee Suen Zheng

Operational Risk - Banks need to have strong internal audit procedures with

follow-up to reduce exposure.

- Banks identify and quantify potential losses by type of

event and the line of business where the event has impact.

Reputation Risk - Banks responsible to ensure employees are well-train.

- Senior management make sure regular and consistent

assessments of internal controls are performed.

- All transactional documents need to be review and

strengthened as necessary and systems should be in place

to deal with customers complaints.

Capital Risk - Refers to the potential decrease in the market value of

assets below the market value of liabilities, indicating the

economic net worth is zero or less.

- Banks need to maintain a level of capital in order to meet

the daily transactions purposes and meet unforeseen or

uncertain environment.

Call Risk - Risk of earning a loss because it must reinvest its

recovered funds at lower interest rates.

Business Risk - Risk that the economy of the market area they serve may

turn down, with falling sales and rising unemployment.

- Banks need to observe and keep the operation and banking

business processes in a performing condition without

experiencing system failure, if there is, should be quickly

recovered.

human resource management in financial services · pdf filemanagement and organisation in...

Documents