Collapse Teaches Lesson in Risk Management

Article excerpt

If anyone needed reminding, the Enron scandal has once again shown that financial trading is a high-risk business.

There are dozens of commercial risk management products designed to mitigate the risk of trading in increasingly complex and turbulent markets. But such tools cannot give the whole picture and, worse, they may also lure users into a false sense of security.

Technology by itself makes a poor watchdog, as the collapse of Enron has shown.

The lessons learned from past trading scandals, in the shape of tighter accounting and disclosure rules, did not prevent Enron's downfall. But neither did the firm's sophisticated risk management technology.

Enron viewed its risk management systems as cutting edge and found a buoyant business in selling risk management services to third parties via its websites.

Enron Credit, the division originally created to help Enron's traders manage credit risk, created, a commercial service that allowed 10,000 businesses to quickly determine the cost of extending credit to their own trading partners.

Enron Credit also created a new credit risk management tool, the Digital Bankruptcy Swap, to allow companies to purchase bankruptcy protection on specific counterparties. Ironically, few customers thought to purchase protection from Enron itself going bankrupt.

This is the big challenge for risk management technology. No matter how many improbable scenarios are used to "stress test" portfolios, real world events seem capable of surpassing them, as the tragic events of September 11 or the collapse of Enron demonstrate.

Nevertheless, the risk management industry claims the growing use of sophisticated technology helps institutions better cope with such events.

James Tomlin, chief executive of risk systems vendor Tamesis, says: "Every so often a disaster hits the financial markets and people's ability to deal with such disasters becomes more sophisticated."

The world is becoming a riskier place and risk management is no longer a subject of interest only to traders of exotic instruments.

Simon Tizard, commercial director at BITA Plus Consultants (BPC), a supplier of portfolio analytics software, says: "We are getting the realisation in the wider community that monitoring risk is becoming a lot more important. It's no longer just something that interests a small group of people. However, as to what happened at Enron, you cannot put that into a risk management system."

While no one could have predicted the speed with which the world's largest energy trader would go bankrupt, warning bells had started to ring in late October as Enron struggled to plug the holes in its rapidly sinking business.

The credit rating agencies downgraded Enron's debt while energy companies shied away from making trades with Enron that would take more than a few weeks to close.

Risk management systems can be programmed to detect such warning signals. The problem, however, is that a big institution will trade many different instruments and each trading desk will have a different concept of what risk means for them and, thus, a different way of calculating risk.

Data may not be normalised and counterparties may be identified differently in different systems, making it difficult to see the global exposure to a particular firm - or country.

In the Russian crisis of 1998, many investment banks took too long to identify what their exposure was because of their inability to consolidate their positions. This is changing, however.

Mike Thrower, director of marketing at Wall Street Systems, the treasury systems vendor, says: "Banks now realise they need to take a cross-organisation view of risk across the globe, for different legal entities and different measures of risk."

The traditional approach to risk management technology has been based on best-of-breed solutions. …