Has our focus on RoE cost future generations $60-200 Trillion?

learning from the earthquake in New Zealand

A recent interview with Epicurean Dealmaker,an anonymous Investment Banker and

blogger offers important insights into the most pressing financial problem of our time1.
Focusing on the Global Financial System and the ongoing Crisis he questions the critical
role of ‘trust’ in supporting the whole System. It is an important question not only for the
financial community but Society. As we all demand more accountable, credible, safe and
transparent Systems,trust is an essential ingredient we have to understand and harness.

Additionally, bank & non-bank funders will not be the sole providers of funding solutions. I
have read Chris Whalen’s Institutional Risk Analytics newsletter for some years. In a
recent article he highlighted the role “lightly regulated” insurance captive vehicles may play
in another bubble.2 Since Regulated Insurers have worked with Captives for years, I felt this
too mis-represented Regulated Insurers role in “The Financial System”. With Solvency II
(EU Market) & accountancy changes impacting Regulated Re/Insurers globally, Basel III
should be considered alongside Solvency II if the changing face of Financial Regulation is
to be understood.
Then today, HSBC reported strong results. Accompanying them, HSBC’s chairman
Douglas Flint continued to raise concerns about Regulatory Capital Levels. Whilst I have
some sympathy, he doesn’t appear to move the debate along from the basic “More Capital
= Less Lending” soundbite we’ve been hearing for months.
I don’t share the destructive “banker bashing” tendencies of many. It does not get credit
flowing to the real economy which is all I’m interested in. I want to add constructively to a
hugely important debate on trust, credibility, risk & transparency. However, over-confidence
& epistemic arrogance are two balloons I will happily puncture when it’s the majority paying
for the mistakes of a few who allowed their critical faculties to be “captured” by the bodies
or groups they belong to.

Background

Like ED & Mr Whalen, I have more than 20 years financial market experience, in my case
as an International Reinsurance Underwriter and Manager latterly at AIG where I was
responsible for its Global Energy Division in Africa, the Middle East, Eastern
Mediterranean & Southern Asia. I have therefore observed and participated in the Global
Financial Crisis from a fairly unique perspective.

Regulated insurers have been central to risk assumption for centuries. They have
supported the development of Risk Management policies that support Society. They
protect people and assets against the economic consequences of individual & systemic
risk events. Commercial/ investment/shadow banks face a considerable challenge of
disproving the growing belief that they offer no social value beyond their role as the
creators and managers of assets and liabilities for which they charge fees and take home
considerable bonuses. After AIG nearly collapsed people suggested kicking an AIG
employee in the US. I empathize with many bankers.
Im no writer. I raise funding for Medium-sized & larger exporters and multinationals around
the world. Transaction sizes may be as low as $10m & as large as $500m. At better “all-in”
funding costs than bank & non-bank funders currently offer. This helps sustain businesses
employment and trade. Structures are usually “portable” - belonging to the client not the
funders - reducing the risks that the client’s working capital liquidity can evaporate when
external financial shocks occur.
We focus on the Trade Receivables asset, an asset few in the financial media discuss,
prompts yawns from bankers (labour intensive compared to Property) but which in the US
alone accounts for around $17T of Balance Sheet Value & real economic activity. Our
transactions rely on the daily assessment of both granular and portfolio risk. The credit
risk of buyer default is usually ‘eligibly mitigated’ for bank funders by regulated insurers
(who may utilize captives). Funders Risk Weighted Assets and Regulatory Capital costs
reduce, management’s risk oversight improves (remember this fine RBS received last year
http://www.bloomberg.com/news/2010-08-03/rbs-fined-8-9-million-by-u-k-fsa-for-not-
checking-on-customer-sanctions.html ) and Pillar II of Basel III is supported more
transparently. Bank lending services rarely offer the client the ability to shut the stable
doors before a horse bolt. Which is why the removal of information asymmetries is critical
to restoring some trust between counter-parties. A good point to explain my background a
little more.

The Growth of Risk

In 1987, I joined a UK insurer in their City of London office; a company that until the mid-
twentieth century relied on externally-derived committee set premium rates to calculate the
fire premia commercial customers should be charged. The assumption back then was that
insurers were unable to differentiate their risk management advice in a way that reduced
the likelihood of losses happening. An absurd pretense it would appear now. However, the
UK Insurance Market was insular with little Capital other than its own. So it had to be kept
‘secure” from collapse. A centrally-developed book of premium rates was felt by regulators
to minimize this “systemic” risk.

It was an enjoyable & diverse job assessing operational, meteorological, nuclear,

geological, geo-political, social, systemic, construction and engineering risks. Yet, not as
complex as banking. The role developed to involve the construction and pricing of risk
transfer structures for large global companies often utilizing Captive vehicles. We assumed
Net & Treaty risk (shared with reinsurers). These transactions were robust and ensured
treaty reinsurers (the “Capital Market” of the regulated insurance marketplace), facultative
reinsurers ( The “spot” market) and business partners like Berkshire Hathaway - for whom
I underwrote in a post-9/11 Joint Venture - would pay claims in the event of contractually
insured losses. I then moved to my Regional role involving travel and meetings with a huge
array of people; Politicians, Regulators, Diplomats, Ministers of State, Plant managers,
Former Intelligence Service personnel and, critically for me, the workers, whose lives are
often on the line and who would tell you (in code) what you needed to hear rather than
what others wanted to tell or write.

I therefore understand the unintentional failures of traditional risk management, particularly

the roles traditional and shadow banking, accountants, regulators and lawyers have (again
unintentionally) played. As complexity increased, so did the speed with which we searched
for yield & Economic Growth. Insurance-based risk assessment and Regulated Insurers
has a big role to play in creating and sustaining economic growth and strengthening bank
& non-bank funding funding for real companies. What is more, this is not “pie in the sky”.
We are closing transactions with some of the the biggest Systemically Important bank &
non-bank funders through a diverse base of global clients.

The role of Trust in Systems - “Never again”, again

In 1988 the Piper Alpha oil-rig exploded killing 167 workers. UK Politicians said “never
again”. As a result Lloyds of London teetered on the brink of collapse as systemic liabilities
grew unchecked. Piper Alpha resulted in a paid loss of $3.4B but triggering a cascade of
financial losses which eventually totaled $21B. Some reinsurers or Syndicates reinsured
the same risk twice or three times. Sound familiar?

Andrew Haldane the Bank of England’s Executive Director of Financial Stability gave a
speech in 2009, entitled “Rethinking the crisis”. In it, he pointed out that paid losses - at
that time - on Lehman CDS derivative “insurance” contracts were settling at around $5B.
Yet, last month he estimated Societal costs of the Global Financial Crisis on the basis of
the loss of future economic growth at $60-200 Trillion. To put this in context, current global
wealth is around $100 Trillion & global GDP in 2009 was $58 Trillion. So a $5B loss that
could have cleared through a Central Counterparty with barely a mention in the press has
destroyed huge wealth for future generations. To put this $5B in context the estimated
Nominal Value of “unregulated” derivative “insurance” contracts (no part of the regulated
insurance industry as AIG found out to their cost) is $1,200,000,000,000,000 (1.2
Quadrillion). As Paul Wilmott points out, 1% of this is still $12 Trillion. There is no excuse
for these insurance contracts which are tradable (unlike Regulated Insurance Contracts
which you cannot “short” or “trade”) to be anywhere other than on an Exchange.

But then, as with the current Financial Crisis, the costs of Lloyds of London’s risk
monitoring failure and “self-regulation” were borne less by “insiders” and more by outside
“Names”; Families who had trusted advisers who they’d meet socially.
Self-regulation had failed. Many lost more than money. The current Crisis is “Never again”,
again.

It is therefore easy to agree with ED’s point that “trust” has been of little value when
measuring systemic risk so far. Systems must not only resist shocks but quarantine
failures. At the individual level it is critical to have confidence that professionals who
manage our money understand how to measure & monitor risk and are accountable for
outcomes. The same applies to Corporate Boards who manage Capital, Agree Budgets,
instruct plant managers to increase production or set “stretch goals” if budget shortfalls are
occurring (analysts must be kept happy!). These managers in turn instruct individuals who
may work heavy machinery or trade. Corporate Social Responsibility and Risk
Management Statements must have meaning. Policing must have teeth. It is no less
important that those for whom we vote understand this too. We are indeed “all in this
together”. Risk is not an after-thought to systems we build, change for political reasons or
invest in. There is often more “waste” and more risks in enforced political systemic
 “change” than the “efficiency savings” they seek. We were designed with two lungs.
Management Consultants would see “redundancy” in human design.

Risk in the Real World - New Zealand

The Real World provides examples for financial regulation. A recent example is the New
Zealand Earthquake. It would be harsh to criticize regulators & legislators. They did there
utmost to ensure Structures - old and new - were retrofitted or built to minimize loss of life
from all but the most unforeseeable events (a “trade-off” must always occur between cost
and benefit but Society should choose these points). However advanced as engineering is,
science offers few guarantees. So NZ regulators/ legislators didn’t get it completely right as
the risk of liquefaction was a “black swan” event; a type Regulated Insurers assume every
day. However, unlike our financial regulators, they didn’t get it very wrong. We now learn
that around one third of the buildings damaged in Canterbury are Constructive Total
Losses. The integrity of the structure kept the majority safe but will need to be demolished
and replaced at an estimated cost of US$4Bn to the Balance Sheets of Society, regulated

In some sense, you could say trust is measured by credit ratings, credit spreads, and even the prices of
financial assets like stocks and bonds themselves. But then again, prices are also the outcome of a
balance of supply and demand. And there remains an enormous amount of money that needs to be put to
work in financial assets.

I think it is safer to simply say that investors have always had to hold their noses when they invest. It’s
just a matter of degree. Certainly, there is no doubt that trust of the financial system and its participants
has plummeted among governments, regulators, and ordinary citizens.

insurers and reinsurers3. But they can and will absorb it. Tokyo & San Francisco
Earthquake scenarios should be “stress-tested”. In advanced democracies with mature
legal systems regulated insurance provides protection against many of the economic
losses people and companies may suffer. Behind local insurers who pay the claims sit
global reinsurers providing a safety net that, were it not there, would devastate the Capital
base of the local insurance market and would cost New Zealand many years of future
economic development.

All systems on which the public rely & support when they fail must be built to protect
individuals against those intent on cutting corners, buying political favour and increasing
personal gain at society’s expense.

with regard to Financial risk I would also agree with many of ED’s comments :-
ED rightly suggests investors have often held their noses when they invest. Given
plummeting trust, restoring confidence will rely on us all taking The Risk Management of
Financial Markets as seriously as, for example, New Zealanders, Japanese and
Californians take their Earthquake risks.

For years, as an underwriter, I would meet CEO’s, CFO’s & Risk Managers of Mining,
Chemical (remember Bhopal?), Pharmaceutical, Power Generation, Electricity Grid,
Petrochemical & Oil Rig facilities from around the world. They would look me in the eye
and assert categorically their “zero tolerance” for fatalities or major environmental
damage.They genuinely believed it. I believed that they believed it. When it comes to risk,
we all believe ourselves to be more risk-averse than we are. Prospect Theory4 teaches us
about this folly.

Adapting Remuneration Structures to align with “Zero Tolerance” statements

If the last 40 years of The great Post-War Boom have taught us anything it is surely that
whenever there is economic value to be “created” people will push risk tolerances to
extract it. One example could be a richly-seamed pillar supporting the roof of an aging gold
mine whose value is high even though its extraction may lead to a roof collapse. Another
would be reducing the “Depreciation to fixed Assets ratio” to < 1 for a few years reducing
the speed at which ‘End of Life’ equipment is replaced but increasing the rate at which
profit is recognized. Penalties for Bad outcomes have been considered little by
shareholders; the price we have paid for sustained “economic growth”. Politicians and
Executives will rightly be shocked and penitent if it happens on their watch. But if you
explain it as I do heartlessly below in a simple example, it is possible to explain how losses
may be ‘allowed’ to happen through poor regulation, poor policing or management
unaccountable for “zero-tolerance” policies.
Executives discuss Corporate Social Responsibility & offer soundbites such as “we’ve
learned from our mistakes”, “we take the risks of …. very seriously” and “we will ensure
this type of event can never happens again”. And they hope & believe that during the
remainder of their employment contract they won’t recur. And often they do not as people
are human and as often over-weigh risk after a loss as they under-weigh it before.
Alongside inadequate mechanisms for whistle-blowing on questionable risk practices and
it is easy to see how risks are ignored in order to achieve financially-focused performance
targets or Key Performance Indicators. The US should be commended for moving on this
subject with provisions in the Dodd-Frank Act5. Other countries should follow and enshrine
this role to Risk Managers whose responsibility should also be to protect Corporate
Reputation.

At the moment, too many executives leave with compensation packages undamaged by
disaster. The replacement takes over seeing their financial future assured after a 3-5 year
contractual employment period. Some “promise” a “laser-like focus” on safety. Investors &
shareholders on the whole applaud these types of statement from plausible, well-educated
individuals. They haven’t until now thought about the downside to their investment of those
pushing risk limits for a greater Return on Equity; at least not until a sudden increase in
uncertainty and reputation risk starts to impact the company’s share price. And why would
investors do this? In the past, they received great returns and their investments constantly
grew. The party was in full swing and the punch-bowl was brimming.

Walking away from the Crash

As ED correctly states, Trust is derived from the latin verb “Credere” - to believe. People
increasingly live in a society where, metaphorically, decision-makers are allowed to drive at
120mph without the headlights on at night, occasionally telling the policeman who stops

Total cost of 20 dead african migrant mining workers ($1-25K life insurance) PLUS
self-insurance costs PLUS insurance premiums ( $3.5m) < Economic value added of
$50k/day additional production for 600 days ($30m)

them for a random check that to the best of their knowledge they have done nothing
wrong. Crashes are inevitable. We have gifted decision-makers for too long with the ability
to walk away from crashes unscathed. It doesn’t matter how big the airbags are when
you’re a passenger in a vehicle that crashes at high speed. This is why the highly technical
and complex debate about the level of Capital banks should hold “to prevent future
failures” misses a key point. If an 800lb gorilla has to hold more Capital than other banks, it
is its shareholders it must answer to when competitors, with lower Capital Requirements
offer the same products cheaper. Society’s capital has been managed, taxed and
destroyed by a small number of people whose interests are not aligned with their
constituents. Often focusing on their end-game - receiving votes or hitting targets within
timelines to reach Financial Performance Targets, “exit” their investment or “book fees”; -
they make decisions comforted by the “you-won’t-go-to-jail” card of supporting “legal
opinion” that ensures minimum legal hurdles have been achieved.
Companies trading internationally should consider the value of a Corporate Social
Responsibility policy that clearly state that, if they are going to step outside of the
International Accounting Standards net that offers a (growing) degree of transparency to
trade in certain territories with questionable regimes, they should say so clearly so
investors can slam no ethical mud at them.

What can we do?

Risk tolerance levels could be enshrined in contractual Risk Authorities within Employment
contracts for Key decision-makers. These should align with CSR and Risk Management
policies stated and monitored by Audit and Risk Management committees and transparent
in Financial Disclosures. The same standards of disclosure can also apply to the use of
“low-tax” centre Financial Vehicles by Audited Companies. The outgoing International
Accounting Standard, IAS 39, requires such “Off Balance Sheet” Transactions to be
declared by “linked presentation”. This was a major issue with Repo 105 & Lehman. The
US FASB did not require such disclosure when London results were consolidated into the
Parent.
Social Networking is increasingly applying moral pressure on those companies with
credibility gaps. Performance targets could therefore be focused not only on unsustainable
RoE but also sustainable Risk-Adjusted Return on Capital (RAROC). Management with
sustainable business practices & strong models that put at their core the well-being of
employees, customers & their reputation will retain credibility with their constituents. This in
turn may encourage those who wish to invest “ethically” to do so. If this means Companies
domiciled in advanced economies and using International Accounting Standards are
disadvantaged, that is a price our Society puts on its protection. These companies will not
achieve “stellar” RoE. But they may achieve a more sustainable RAROC.
 Trust can only begin to be restored if decision-makers take actions that allow us to take a
credible path.Potentially a societal role for International Accounting Standards which
Egypt, Libya, Algeria nor Tunisia have yet signed up to ( G20 Take note. Do we provide
“Aid” to any other countries who do not use IAS?) Political parties should adopt a ‘Know
Your Donor‘6 policy accepting donations only from transparent sources who trade in
countries who sign up International Accounting Standards.This, too, may begin to restore
Trust & Confidence. It may not work for the Arms & Defence Industries but that too is a
complex area.

Data quality, timeliness and transparency are critical in effectively managing risks &
creating socially useful credit, by which I mean credit that enables jobs to be created and
trade to occur. Insurers can support these aims. They have been helping society shut
stable doors before horses bolt for years. Good Risk management and transparency
sustains “trust” in finance & business between clients, customers, investors, funders &
insurers.

Hernando de Soto, an influential economist adds some ballast to these points with a
speech he gave last year that indirectly addresses the role regulation must play in reducing
inequality and increasing trust in this information age, people, like frozen water, exploit
weaknesses in structures that have in many peoples eyes relied on one rule for the Elites
and another for the Majority. Transparency of goals, reducing complexity and protection
against greed/ego (central to risk blindness & social inequality) offer a guide to restore
trust within the financial system.7

Regulated Insurers have - on the whole - contributed to Society. But this does not mean
Bankers, Underwriters, Politicians, Hedge Fund Managers or Regulators have no ethical or
moral compass. If we can set Magnetic North, which may have a chance of reducing
Systemic Risk.

1. http://trustedadvisor.com/trustmatters
2. http://blogs.reuters.com/christopher-whalen/2011/02/23/aig-redux-is-the-fed-blowing-
bubbles-in-structured-finance-and-insurance/ .
3. http://www.bloomberg.com/news/2011-02-27/christchurch-faces-task-of-rebuilding-after-
earthquake-strikes.html
3. http://en.wikipedia.org/wiki/Prospect_theory
4. http://www.boardmember.com/2010-Five-Big-Bangs-in-Corporate-Governance.aspx?
utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+latest-content+
%28Recently+Posted+-+Boardmember.com%29
5. http://en.wikipedia.org/wiki/Know_your_customer
6. http://www.scribd.com/doc/49556796/Staying-in-the-Dark-About-Derivatives-Will-Bring-
Economic-Collapse

David McKibbin 28/2/11 www.thecreditplumber.com @Creditplumber