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Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 1
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
jamesesz@yahoo.com
jamesesz.wordpress.com
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 2
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
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 3
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.
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 4
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
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 5
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
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 6
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
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 7
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.
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 8
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)
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 9
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-
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Keith H. Black (2004), Managing a Hedge Fund: a complete guide to trading,
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Prasanna Chandra (2006), Investment Analysis and Portfolio Management, 2nd
edition, Tata McGraw-Hill.
Liaw, K. Thomas (2004), Capital markets, Thomson South-Western.
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 10
i Figure 1 Money Center bank – Adapted from Peter Rose and Sylvia Hudgins, 2008, p70-71
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 11
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
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 12
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
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 13
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.
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 14
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
Management and Organisation in Financial Services September 11, 2009
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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
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 16
vii
Tradeoff between Risk and Return
Loan Originator
Loans
Special Purpose Vehicle
Asset-backed securities
Underwriter
Institutional investors
Credit EnhancerRating Agency
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 17
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
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 18
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
Management and Organisation in Financial Services September 11, 2009
Ee Suen Zheng Page 19
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.
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