PwC faces 3 major trials that threaten its business

Philip Merrill’s notes:

1) Do Auditors need to be seasoned professionals in the businesses they audit?

2) Or, CPA’s that have to take the customers word for accuracy in financial statement representation including notes.

By Francine McKenna

Published: Aug 15, 2016 12:32 p.m. ET

The Big Four global audit firms go to court all the time but are rarely put on trial.

PricewaterhouseCoopers LLP, the U.S. member of the global professional-services giant, is currently facing not one, not two, but three significant trials for allegedly negligent audits. An unfavorable verdict in the trial currently playing out in a Florida state court could inflict a significant monetary wound. That, combined with a possible unfavorable judgment in another trial scheduled for federal court in Alabama in February of 2017, and a third in a Manhattan federal court within the next year, may be fatal.

The case against PwC brought by the Taylor Bean and Whitaker bankruptcy trustee is quite unusual, said Tom Rohback, an attorney with Axinn Veltrop & Harkrider. That’s because it is one of the few cases from the credit crisis seeking to hold auditors responsible for crisis-era losses to actually go to trial.

“Beyond the $5.5 billion sought, the case is unusual because the plaintiff is the trustee of the entity that committed the fraud and is suing not its own audit firm but the audit firm of the institution it defrauded,” he said. “

Settlements preferred

In the U.S. the Big Four audit firms have, in recent history, almost always settled because of the fear that one catastrophic jury verdict could shut them down for good. In addition, trials show the public just how often auditors fail to detect fraud. Settlements prevent the public from hearing that in open court and typically put partners’ pretrial testimony under confidential court seal forever.

‘The trial has the potential to influence public perception of auditors, as well as strategies used by the plaintiff lawyers that try cases against them, regardless of the eventual verdict.’

Tom Rohback, Axinn Veltrop and Harkrider

The bankruptcy trustee for Taylor Bean & Whitaker Mortgage Corp., once the 12th-largest U.S. mortgage lender, sued PwC for $5.5 billion in damages in 2012 after the bank went bankrupt in August 2009. Federal regulators, not the bank’s auditor, Deloitte, uncovered a $3 billion fraud involving fake mortgage assets. The bankruptcy trustee for Taylor, however, alleges that PwC was negligent in not spotting the fraud from its perch as auditor of Colonial Bank, which bought the allegedly fake mortgages that Taylor Bean had originated and that made Taylor Bean’s losses worse.

Beth Tanis, the lead attorney for PwC from the firm King & Spalding, issued a statement at the beginning of the trial: “PricewaterhouseCoopers did not audit or perform any other services for Taylor Bean. With regard to the services performed for Colonial Bancgroup, one of the targets of Taylor Bean’s fraud, PricewaterhouseCoopers did its job,” said Tanis. “As the professional audit standards make clear, even a properly designed and executed audit may not detect fraud, especially in instances when there is collusion, fabrication of documents, and the override of controls, as there was at Colonial Bank. We are confident that a jury will understand the applicable rules and standards in this case and decide accordingly.”

A spokeswoman for PwC declined to provide further comment.

Six Taylor Bean executives went to jail for their roles in the fraud. The bank’s former chairman, Lee Farkas, was sentenced to 30 years in prison. Taylor Bean auditor Deloitte settled with the trustee for an undisclosed amount in 2013.

The bankruptcy route

Colonial Bank, a Montgomery, Ala., institution with $25 billion in assets, also filed for bankruptcy in 2009. The Colonial Bank bankruptcy trustee and the Federal Deposit Insurance Corp. brought a lawsuit in 2012 against PwC for negligence as the auditor of Colonial Bank, claiming $1 billion in damages. That case is scheduled to go to trial in February.

The FDIC’s suit was its first against an auditor for a financial-crisis-era bank fraud or failure. Crowe Horwath LLP, Colonial’s outsourced internal audit firm, is also named in the Colonial suit. (Remember Arthur Andersen internal and external auditor for Enron?)

Tanis, in her opening statement at the trial on Aug. 9, said that no one at Taylor Bean relied on PwC’s audit of Colonial Bank, even though Colonial was Taylor Bean’s biggest mortgage buyer.

“There will be no document showing you that these directors or anybody else at Taylor Bean ever received these Pricewaterhouse audit reports, actually read these Pricewaterhouse audit reports and relied on them,” she said.

Largest Banking Regulatory Fines (2008 – 2015)

Bank

Date

Fine Amount

Description

Bank of America

August 2014

$16,650,000,000

Settlement to resolve allegations of misselling mortgage-backed securities. The … Show More

Bank of America

February 2012

$11,820

Part of the National Mortgage Settlement; $8.6bn paid as relief to borrowers, $3 … Show More

Bank of America

January 2013

$11,600

Settlement resolving repurchase requests of faulty mortgage sales. Bank agreed t … Show More

Bank of America

March 2014

$9,330

Settled charges of misleading investors over mortgage backed securities.

Citigroup

July 2014

$7,000,000,000

Settled charges of misleading investors over mortgage backed securities. $4bn pa … Show More

JPMorgan Chase

November 2013

$13,000,000,000

Part of $13bn settlement; $4bn paid as relief to consumers, $2bn paid as civil penalty

Wells Fargo

February 2012

$5,350

Part of the National Mortgage Settlement; $4.3bn paid as relief to borrowers, $1 … Show More

JPMorgan Chase

February 2012

$5,290

Part of the National Mortgage Settlement; $4.2bn paid as relief to borrowers and … Show More

JPMorgan Chase

October 2013

$4,000

Part of $13bn settlement; settles federal and state claims by FHFA.

JPMorgan Chase

October 2013

$4,000

Settlement over securities laws violations in connection with mortgage-backed se … Show More

Bank

Date

Fine Amount

Description

Data collected from the Financial Times on May 20, 2015.

See more details ›

Taylor Bean’s employees, customers and creditors, who all lost something when the firm went bankrupt, were relying on Colonial Bank to operate as an honest business partner that was accurately reflecting its financial obligations to Taylor Bean, a point emphasized by Steve Thomas, the attorney for the Taylor Bean trustee, in his opening statement on Tuesday.

Thomas told the jury that PricewaterhouseCooper’s failure mattered, because many people were counting on it to do its job. “PwC was lending credibility to Colonial’s financial statements. PwC’s failure mattered because Taylor Bean and Whitaker, and others, relied on PwC to do its job,” he said.

‘PwC was lending credibility to Colonial’s financial statements. PwC’s failure mattered because Taylor Bean and Whitaker, and others, relied on PwC to do its job.’

Steve Thomas, attorney for Taylor Bean trustee

PwC and the other Big Four accounting firms all had major clients that failed, were bailed out or were effectively nationalized during the crisis. None of those cases went to trial. Ernst & Young LLP paid $99 million to investors and $10 million to the New York attorney general’s office for its role as auditor of Lehman Brothers Holdings Inc. KPMG settled its exposures early, and within a week of each other in 2010 settled for an undisclosed amount for its audit of New Century, another big mortgage originator, and paid $24 million for its audits of Countrywide Bank, which was distressed when it was sold to Bank of America BAC, +0.74% .

Deloitte settled its exposure as auditor of Bear Stearns for $19.9 million. Bear Stearns was bought for a relative pittance by J.P. Morgan JPM, +0.61%  during the crisis. Deloitte was also the auditor of Washington Mutual and contributed $18.5 million to a settlement with investors for its negligent audits. Deloitte went on to earn hundreds of millions of dollars reviewing J.P. Morgan’s exposure to foreclosure fraud claims for Bear Stearns and Washington Mutual mortgages it inherited as part of those purchases.

The litigation hit

Those settlements pale in comparison to the total of $6.5 billion that Taylor Bean and Colonial Bank trustees are looking for from PwC. On Aug. 5 U.S. District Judge Victor Marrero in Manhattan rejected PwC’s request to dismiss MF Global’s lawsuit alleging professional malpractice that contributed to the October 2011 bankruptcy of the brokerage firm once run by former New Jersey Gov. Jon Corzine. That suit is seeking $1 billion in damages, bringing the total potential claims PwC is facing over a very short period to $7.5 billion.

Jim Peterson, a former in-house attorney for Arthur Andersen and the author of the book “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms,” has periodically asked the question on his blog: “How big is the ‘worst case’ litigation hit that would disintegrate one of the surviving Big Four?”

Back in September 2006, a report by the consulting firm London Economics to the EU markets commissioner modeled the collapse of a Big Four partnership in the U.K. That model quantified the level, according to Peterson, “of personal sacrifice, beyond which the owner-partners would lose confidence, withdraw their loyalty and their capital, and vote with their feet.”

Peterson’s analysis concluded that critical numbers of partners would defect and put a firm into a death spiral, if they faced a partner-income-distribution reduction of 15% to 20% that extended over three or four years. Peterson extended the figures to the global level to calculate breakup figures for the Big Four. That brought the number down from an optimistic maximum of about $7 billion to about $3 billion.

However, global numbers assume that a Big Four network under deadly financial threat could hold it together and count on the support of its member firms and partners around the world. But that’s not what happened to Arthur Andersen after the bankruptcy of client Enron and an indictment for obstruction of justice in 2001. Instead, Andersen’s non-U.S. member firms flew the coop in 2002, and the firm itself was forced to fold.

Based on the experience of Arthur Andersen, it is unlikely, Peterson told MarketWatch, that PwC’s non-U.S. member firms would pitch in to pay a U.S.-based catastrophic court judgment or a series of them. Peterson’s most recent update of his tipping-point calculation, completed in early 2015, assumes the U.S. firm is left to pay its own way out, as was Andersen’s U.S. firm. The worst-case tipping points for the U.S. practices shrinks from the $3 billion global number down to $900 million for the most financially vulnerable of the four firms.

These numbers matter, according to Peterson, because the loss of another Big Four firm would throw the entire system into chaos.“There is no contingency plan or readiness among the three survivors to stay in an even more risky business or take on the failed firm’s risky clients or outstanding litigation claims,” he said.

The Petrobras angle

The three lawsuits against PwC that are on trial or going to trial in the next year all name only the U.S. firm as a defendant. Another large case names PwC’s Brazil member firm for its allegedly negligent audits and failure to detect a multibillion-dollar bribery and corruption fraud at the state-sponsored oil company Petrobras.

Those plaintiffs, which include the Bill Gates Foundation, could decide to name PwC U.S. as a defendant or eventually require the U.S. firm to ante up to pay a verdict that would otherwise knock out the Brazilian firm, a key cog in its service network for multinational clients.

MarketWatch asked Rohback why PwC would choose to go to trial given the stakes. “Oh, they probably didn’t choose to try the case. They just haven’t hit on a settlement number they can stomach yet,” he said.

PwC has few options at this point, Rohback said. “There’s still time to settle, and they could win it. If they lose, they can ask the judge for a stay in enforcing any judgment until an appeal can be heard.”

Florida law prohibits judgments that would bankrupt a defendant. PwC would probably be reluctant to go to court and open its books to prove it was too poor to pay a judgment. However, in a previous case against an audit firm in Florida tried by Taylor Bean trustee attorney Thomas, the court allowed audit-firm partners to be paid “profits” each year before considering claims of any parties damaged by the firm’s frauds or gross negligence.

Audit firms have no duty to reserve for or disclose serious legal contingencies, since they are partnerships. Thomas had to file a motion to force discovery because he suspected that while the case was under appeal “assets have been or are being dissipated or diverted while such a stay is in place.”

Francine McKenna

Francine McKenna is a MarketWatch reporter based in Washington.

Email Francine at fmckenna@marketwatch.com

New From Credit Suisse: Bonds for Self-Inflicted Catastrophes

Sagacious LLC will help customize a similar program to save op risk regulatory capital at your institution. 

By ANUPREETA DAS and LESLIE SCISM
May 16, 2016 1:21 p.m. ET WSJ

Credit Suisse Group AG is going to give it a try in the bond market. The bank plans as early as this week to launch unusual new securities that would pay investors relatively high interest rates. The catch is Credit Suisse could take their principal if incidents like rogue trading, information-technology breakdowns or even accounting errors lead to massive losses for the bank, people familiar with the offering said.

The deal is a first-of-its-kind twist on the “catastrophe bonds” that insurers have used for years to lay off the risk of natural disasters like hurricanes. Credit Suisse’s offering covers self-inflicted disasters as well as external events and has been marketed to hedge funds and other big investors.

The insurance feature of the bonds would be triggered if Credit Suisse’s annual operational risk-related losses cross $3.5 billion. Buyers have a level of comfort, however, because it’s a “second-event” bond. The most any single event could contribute to the trigger is $3 billion, meaning it would take more than one event to cross the threshold. The odds of that are remote: Credit Suisse has put them at roughly 1 in 500, the people said.

A Credit Suisse spokeswoman declined to comment.
The appetite for such offerings in the capital markets, as persistently low interest rates send investors searching for higher yields, is encouraging Wall Street companies to test new uses for the structure.

MORE

Heard on the Street: Credit Suisse Takes Out Insurance on Itself
Insurance-industry executives said that they haven’t previously seen a bank attempting to tap capital markets to cover this type of risk. The move has its roots in regulation. Under European bank rules, banks must calculate operational risk and may use insurance products as part of meeting their capital requirements, according to industry participants.

In general, operational risk is the possibility of losses resulting from insufficient internal controls, errant systems or rogue employees. The Credit Suisse offering doesn’t cover market losses from trading that is authorized by the bank, some of the people familiar with the matter said.

Paul Schultz, chief executive of the Aon Securities unit of global insurance brokerage Aon PLC, said an offering like Credit Suisse’s reflects “growing investor sophistication on the underwriting side and a general view that to continue to grow the asset class, investors are going to have to expand from simply writing property risk.”

Zurich-based Credit Suisse, via a Bermuda company called Operational Re, plans to issue a five-year bond of up to 630 million Swiss francs ($646 million) to qualified institutional buyers such as hedge funds, asset managers and firms that pool together capital from pension funds. The bonds are part of a planned package that includes an insurance policy of up to 700 million francs issued by Zurich Insurance Group. Most of the cost of any claim would be paid for by the bonds. The size of the bond offering and the policy limits ultimately will be determined by investor interest, the people said. A spokeswoman for Zurich said the company’s policy is not to comment on current or potential commercial relationships.

The coupon is expected to be in the “mid-single digits,” one of the people said—higher than what Credit Suisse was initially planning, in order to entice investors to buy the novel security.

Credit Suisse last week reported a first-quarter net loss of 302 million francs, compared with a profit of 1.05 billion francs in the same period last year. The bank’s new chief executive, Tidjane Thiam, has been retooling the bank away from its investment-banking business toward its more stable wealth-management unit.

European banks have long used insurance products to meet capital requirements set by regulators or to unload risk from their balance sheets. Before the financial crisis, giant insurer American International Group Inc. sold financial derivatives known as credit-default swaps to major European banks as insurance against losses in their holdings of subprime mortgage assets. AIG’s near collapse in 2008 in the wake of the housing-bubble burst was tied to the massive volume of credit-default swaps it had sold.

As for Credit Suisse’s new bond, the bank can’t call on the money to cover regulatory liabilities or government fines, the people said. Losses from rogue trading, which have hobbled large banks such as Société Générale and UBS Group AG in recent years, could be covered by the insurance provided by the bond, but any fines stemming from it wouldn’t be, they said.

Write to Anupreeta Das at anupreeta.das@wsj.com and Leslie Scism at leslie.scism@wsj.com

Sagacious LLC can customize a disaster bond for your institution.

What is the amount of Operational Risk Capital at Your Bank?

Civil Antitrust Lawsuits Reinstated Against 16 Banks in Libor Case
May 23, 2016 By Nicole Hong, WSJ
Appeals court restores private suits against Bank of America, J.P. Morgan Chase, Citigroup and others
The lawsuits accuse 16 major banks—including Citigroup, J.P. Morgan and Bank of America—of collusion in manipulating the London interbank offered rate, or Libor, to the detriment of the banks’ consumers.

In a setback for some of the world’s largest financial institutions, a U.S. appeals court on Monday reinstated the private antitrust lawsuits filed against 16 banks for allegedly rigging Libor interest rates.

The ruling from the Court of Appeals for the Second Circuit reverses a lower court decision from 2013, in which U.S. District Judge Naomi Buchwald dismissed the claims because she said the banks’ alleged conduct did not violate federal antitrust laws.

The lawsuits accuse 16 major banks—including J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc.—of collusion in manipulating the London interbank offered rate, or Libor, to the detriment of the banks’ consumers.

The plaintiffs, who owned various financial instruments that were affected by Libor, claim the returns on their investments were depressed by the banks’ collusion. The lawsuits were filed by several groups of plaintiffs, including the local governments of cities like Baltimore, San Diego and Houston.

Judge Buchwald had dismissed the antitrust claims, saying the plaintiffs failed to show they were injured by the alleged rate manipulation. She said that because setting Libor was a “cooperative endeavor,” there could be no anticompetitive harm to consumers.

But the appeals court Monday disagreed and kicked the case back to the lower court for further proceedings. A three-judge panel found that the plaintiffs did show an antitrust injury “by alleging that they paid artificially fixed higher prices.”

Judge Buchwald in 2013 had allowed other claims by the plaintiffs to proceed, including allegations that the banks breached commodities laws, but the antitrust claims were a central part of the litigation, as violations can require a defendant to pay triple damages.

The appellate judges noted that the plaintiffs will still have to prove at a later stage whether the allegedly corrupt Libor rate did have an influence on the prices of their financial investments.

If this litigation is ultimately successful, the potential total bill to banks could be in the billions, analysts have estimated.

A lawyer representing the banks declined to comment, while a lawyer for the plaintiffs did not immediately respond to a request for comment.

Libor, a widely used benchmark that helps set interest rates for everything from mortgages to corporate loans, is calculated daily for different currencies based on estimated borrowing rates submitted by banks on panels. The lawsuits are targeting banks on the panel that sets U.S. dollar rates under Libor.

These private lawsuits are separate from the sprawling criminal and civil probes around Libor rigging, which began in 2008 and have implicated traders around the world. Regulators have accused big banks of letting their traders and executives raise Libor rates up or down to benefit their trading positions.

About a dozen financial firms have settled charges of manipulating Libor, and many have pleaded guilty to criminal charges. The largest penalty imposed was the $2.5 billion paid by Deutsche Bank AG last year.

In total, U.K. and U.S. authorities have imposed sanctions of more than $6 billion in the Libor cases. A series of global investigations are still ongoing, but The Wall Street Journal reported in February that regulators in the U.S. and U.K. are preparing to bring a final round of civil charges against several banks in the probe.

Write to Nicole Hong at nicole.hong@wsj.com

Reforming banking’s risk culture requires breaking “accountability firewall”

Reforming banking’s risk culture requires breaking “accountability firewall”

September 11, 2013 @ 8:09 pm

By Guest Contributor

By Henry Engler, Compliance Complete

NEW YORK, Sept. 11 (Thomson Reuters Accelus) – If there is one part of the cultural makeup of Wall Street that remains firmly in place despite the financial crisis and subsequent avalanche of regulations, it is the reticence among those who lose money to come clean early.

Many of the most spectacular losses in recent years — whether the JPMorgan “London Whale” episode, the UBS “rogue trader” incident, or Jerome Kerviel’s manipulation of internal systems at Société Générale — have all had one thing in common: concealment of trades gone badly wrong, or at a minimum, a lack of transparency and early acknowledgement of losses. And if one can point to a single reason for such behavior, it is the well-known fact that raising the red flag would mean the individual responsible would be shown the door.

The blowup at JPMorgan was noteworthy not just for the size of the loss ($6.2 billion), coming in a unit that was supposed to hedge risk, but also for senior management’s role in cultivating a culture that discouraged individuals to identify problems.

“Ina (Drew) never wanted to hear bad news,” said a JPMorgan bank executive familiar with the management style of the former Chief Investment Officer where the loss was incurred.

In a lengthy piece by the New York Times [1] last year that examined the failure of controls at JPMorgan, CEO Jamie Dimon said: “Honestly, I don’t care what second-guessers say in life If anyone in the company knew, they should have said something. No one came to us beforehand and said we have a problem we should be looking at.”

Dimon’s comment could well have been made by other chief executives. In a scathing review of banking practices by the UK Parliamentary Committee on Banking Standards [2] earlier this year, the panel highlighted a disturbing lack of awareness and accountability by senior managers:

“Too many bankers, especially at the most senior levels, have operated in an environment with insufficient personal responsibility. Top bankers dodged accountability for failings on their watch by claiming ignorance or hiding behind collective decision-making… Ignorance was offered as the main excuse. It was not always accidental. Those who should have been exercising supervisory or leadership roles benefited from an accountability firewall between themselves and individual misconduct, and demonstrated poor, perhaps deliberately poor, understanding of the front line.”

The “accountability firewall” might well have been facilitated by management practices that hindered the type of information flow necessary in an effective risk culture. In a separate survey [3] by the London School of Economics, the findings of which are due to be updated in coming weeks, researchers pointed to the fear of punitive action as a primary concern. The study quoted one individual who summarized the views of many:

“One of the things that helps greatly with the flow of information through the organization is how it’s reacted to when it gets to the next level. So being able to report risks openly and honestly without getting your head bitten off from the second that’s done is crucial […] For example, if I told you something that might be happening you do not want your directors on your back saying ‘What have you told them? Why?’ So managing the flow of information through an organization to ensure key stakeholders are properly engaged is quite important […] to avoid the wrong reaction happening.”

What has led us to this state of affairs? And how might it be corrected?

Excesses of short-termism

Establishing a robust risk culture is a subject that management consultants have written volumes on. And when one scours the long list of recommendations, embedding risk awareness across the organization and fostering an environment in which people are comfortable challenging others without fear of retribution are critical components.

But this ideal state would appear far from the current reality at many institutions. In understanding what has led us to an environment of fear and lack of accountability, some argue that the finance sector has taken short-termism to the extreme. The enormous pressures that individuals are under to meet their financial targets, and how those goals are wrapped-up in the quest to meet quarterly revenue and profit objectives, create disincentives to identify risk events early.

“The connection that hasn’t been made is how short-termism invites corrupt behaviour — lawful, but corrupt” says Malcolm Salter of the Harvard Business School, who has written extensively on institutional corruption [4] on Wall Street. In order to rectify the problems, many banks have taken a much closer look at compensation policies, but this may not be enough. “Who is modeling the behavior at the banks?” asks Salter. “There is the cultural aspect of the business: how do you change that culture short of the firm having a breakdown.”

In the UK, the Committee on Banking Standards proposed a series of sweeping reforms aimed at establishing much great accountability on senior management. Among these would be the “replacement of the statements of principles and the associated codes of practice, which are incomplete and unclear in their application, with a single set of banking standards rules to be drawn up by the regulators. These rules would apply to both senior persons and licensed bank staff and a breach would constitute grounds for enforcement action by the regulators.”

The rules proposed, and which have been embraced by the UK government, are intended to shift the burden of proof of management failure away from the regulator and onto senior management, who will have to “demonstrate that they took all reasonable steps to prevent or offset the effects of a specified failing.” But the new regulatory standards are only UK-specific. International coordination is needed to guard against regulatory arbitrage.

Indeed, what Salter and others see within the industry are ongoing attempts to “game” the system, and legally circumvent many of the regulations that have been piled on since the 2008 crisis. It is this legal gaming, if you will, that remains problematic when envisioning an enhanced risk culture and ethical banking environment. To change that type of behavior requires the type of leadership from the top that we have yet to see, and a regulatory environment that enforces accountability.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus [5]. Compliance Complete provides a single source [6] for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus [7])

[1] New York Times: http://www.nytimes.com/2012/10/07/magazine/ina-drew-jamie-dimon-jpmorgan-chase.html?pagewanted=all&_r=0

[2] UK Parliamentary Committee on Banking Standards: http://www.parliament.uk/documents/banking-commission/Banking-final-report-volume-i.pdf

[3] separate survey: http://www.lse.ac.uk/researchAndExpertise/units/CARR/pdf/Risk-culture-interim-report.pdf

[4] institutional corruption: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2247545&download=yes##

[5] Thomson Reuters Accelus: http://accelus.thomsonreuters.com/

[6] provides a single source: http://accelus.thomsonreuters.com/solutions/regulatory-intelligence/compliance-complete/

[7] @GRC_Accelus: https://twitter.com/GRC_Accelus

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Thomson Reuters journalists are subject to an Editorial Handbook which requires fair presentation and disclosure of relevant interests.

JP Morgan fined $920m and admits wrongdoing over ‘London Whale’

US’s biggest bank to pay penalties to US and UK regulators for ‘unsound practices’ relating to $6.2bn losses last year

JP Morgan has agreed to pay about $920m in penalties to US and UK regulators over the “unsafe and unsound practices” that led to its $6.2bn London Whale losses last year.

The US’s biggest bank will pay $300m to the US office of the comptroller of the currency, $200m to Federal Reserve, $200m to the securities and exchange commission (SEC) and £137.6m ($219.74m) to the UK’s financial conduct authority.

JP Morgan admitted wrongdoing as part of the settlement, an unusual step for a finance firm in the crosshairs of multiple legal actions.

“JP Morgan failed to keep watch over its traders as they overvalued a very complex portfolio to hide massive losses,” co-director of the SEC’s division of enforcement, George Canellos, said.

“While grappling with how to fix its internal control breakdowns, JP Morgan’s senior management broke a cardinal rule of corporate governance and deprived its board of critical information it needed to fully assess the company’s problems and determine whether accurate and reliable information was being disclosed to investors and regulators.”

In a statement the OCC blamed “unsafe and unsound practices related to derivatives trading activities conducted on behalf of the bank by the chief investment office (CIO)”, for the fine.

The OCC said its inquiries had found inadequate oversight and governance to protect the bank from material risk, inadequate risk management, inadequate control over pricing of trades, inadequate development and implementation of models used by the bank, and inadequate internal audit processes.

The US authorities are still pursuing JP Morgan. The Justice Department is pursuing criminal charges against some of the bankers responsible for the massive loss. In an indictment unsealed in federal court this week Javier Martin-Artajo, who oversaw trading strategy at the bank’s London office, and Julien Grout, a trader who worked for him, were charged with securities fraud, conspiracy, filing false books and records, wire fraud and making false filings to the SEC.

Grout’s lawyer said this week that his client was being “unjustly played as a pawn in the government’s attempt to settle its highly politicized case against JP Morgan Chase”.

The bank also faces another fine from the commodity futures trading commission which is still investigating whether the bank is guilty of market manipulation.

Jamie Dimon, the bank’s chairman and chief executive, initially dismissed the mounting losses at the bank’s London offices as a “tempest in a teapot”. In a statement Dimon said: “We have accepted responsibility and acknowledged our mistakes from the start, and we have learned from them and worked to fix them. Since these losses occurred, we have made numerous changes that have made us a stronger, smarter, better company.”

This week in a letter to staff he warned: “Unfortunately, we are all well aware of the news around the legal and regulatory issues facing our company, and in the coming weeks and months we need to be braced for more to come.”

The admission of wrongdoing is a major victory for the SEC. US judges in recent years have questioned fines where banks were allowed to neither admit nor deny wrongdoing. Judge Jed Rakoff blocked a 2011 SEC settlement with Citigroup because he said the lack of an admission of wrongdoing made it impossible for him to determine whether the fine was “fair, reasonable, adequate and in the public interest”.

 

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The 3 Ms of Risk Management

The 3 Ms of Risk Management

 

 

 

Recent market event have pointed to increasing volatility. As has happened all too many times in the past, risk management disasters continue to plague the industry and show up on the front page of the newspapers. Given the potential for these disasters to occur, lets discuss some required risk management capabilities.

 

Consider the following scenarios:

 

A major market move occurs. The Chief Risk Officer (“CRO”) of a broker/dealer wants to know right now what effect this has on the firm. Are they better or worse off? What actions should be taken? To determine the best course of action the CRO needs to know real-time what the positions are and the potential P&L effect. The CRO must also be able to perform a risk analysis immediately. As we have seen, inability to do this will consume resources, raise the firm’s risk profile and possibly cause losses as a result of the market move.

 

A major firm announces a significant profit restatement. The CRO of a major retail brokerage wants to know which accounts will be affected the most. The CRO needs to know real-time which accounts have concentrations in that industry and SIC code. Since it isn’t clear yet what the full effect of the restatement will be on security prices, can the CRO perform a what-if analysis on specific accounts to determine the potential effects on the firm and the accounts so that proper actions can be taken? Inability to do this real-time will consume resources and increase the risk profile of the firm and the accounts.

 

In both cases, could the CRO have set up early warnings so that the risk systems would have generated alerts as to problem positions or accounts when specific actions occur so that the CRO can spend less time finding risks and more time managing risks?

 

The industry has spent many dollars effecting comprehensive risk management capabilities. Ultimately risk management is, however, a process that requires tools and the right mindset, not just a system that measures risk. The purpose of risk management is the following: minimize the probability that an error occurs AND that it goes unnoticed. To do that, a firm must have all the components of effective risk management. The firm must have the ability to perform the 3 Ms of Risk Management: Measurement, Monitoring and Management of risk. In this paper, we will outline the basic capabilities of each of the three areas.

 

 

Risk Measurement

 

All firms must have the capability to measure their risks. Most firms have risk measurement systems. However, there is a lot more to it than that. Risk measurement involves ALL aspects of the capability to measure risk, not just having systems. To measure risk effectively and accurately, the firm must have accurate and timely information as to its positions, its counterparties and all relevant information regarding its positions and counterparties. This information should ideally be available on a real-time basis as markets move very rapidly and soon the risk analysis may no longer be valid. Measuring this information solely on an overnight (or end of day) basis will not be sufficient as market conditions change during the day, and customer and counterparty activity changes the firm’s risk profile constantly. It is also not sufficient to simply do this several times a day. As market conditions change, the value of the firm’s and its customers’ positions changes accordingly, either favorably or unfavorably. In addition, as customers do trades during the day the firm must be able to track its customers’ accounts as they transact business. This information must be accurate, accessible in a timely manner and able to be retrieved from the firm’s computers and sent to the relevant analytical models for risk evaluation. During some recent risk events, many firms learned that they could not do this effectively, much to their dismay.

 

So what does effective risk measurement entail? Several key components are required:

 

The risk measurement methodologies used must accurately measure the risks. There are many different ways to measure risks and firms use most of them. The two basic necessities for a risk measurement methodology to be effective are that they must reflect the risks they measure and all relevant parties must understand them.

 

Different kinds of firms will require different kinds of risk measures. The measures needed for a portfolio-based approach to risk measurement are not exactly the ones needed for a retail operation. The portfolio approach requires position, position attribute, counterparty and counterparty attribute data. A retail operation will require all that and extensive information at the account level so it can see what individual accounts are doing real-time.

 

The firm must be able to examine its risks at any level and aggregate up or drill down to any desired degree. For example, a broker dealer must be able to measure risk by security, security type, counterparty and type, industry or SIC classification, currency, geographical location, etc. The B/D should then be able to aggregate up or drill down in any direction (for example by country by currency or vice versa). A retail brokerage should be able to measure risk by account, by account type, by industry, SIC code, etc, and aggregate up. They should also be able to drill down to the account level after starting with a portfolio approach. In addition, a retail brokerage needs to perform sophisticated margin calculations on a wide variety of products. Also, they would need to be alerted when specific activities occur in selected accounts, e.g., large trades or prohibited activities.

 

The firm must be able to perform scenario and what if analysis on a real time basis for any of its risk measurement categories. For a retail operation, this means even at the account level.

 

The analytical models used to measure risk must be accurate and measure the right risks. The models must be appropriate to the business and the products. Different products may require different kinds of models and there is nothing wrong with that. Use as many models as is necessary and no more.

The inputs to the models must be accurate. Many firms have a problem with their data and getting it to the right system at the right time. The data must be accurate, clean, and timely. This applies to model-generated data (including the results of risk analysis) as well as historical market data. Without accurate inputs, the model will give misleading results, leading to inaccurate decision-making.

 

The connections between the systems must be accurate. Feeder systems must feed the inputs to the risk model on a timely and accurate basis, just as the risk system must feed other systems in the same manner.

 

The systems must work automatically. You should not have to do anything extra for the system to be measuring risk accurately and timely.

 

The firm should periodically assess its systems and their ability to perform, effecting updated capabilities when necessary.

 

 

Risk Monitoring

 

For effective risk management to take place, risks must be monitored. A firm that simply measures risk three thousand ways but does not monitor it on a timely basis will likely suffer at some point. Risk monitoring includes all aspects of ensuring that accurate risk measurement information is available to the right people on a timely and accurate basis. What does effective risk monitoring entail? Several key capabilities are required.

 

The firm must have timely and accurate risk information available to the right people at the right time.

The firm must have a set of comprehensive risk reports generated during the day. The reason that a set of reports is necessary is that different levels of management require different levels of risk information. The key criterion is that the reports reflect the degree of granularity and breadth of information required to optimize the decision-making capabilities of the party that gets the reports.

The firm must also have this information available on a real-time basis. This means that it must be available online for the parties that require it so they can see what is going on at all times. The same issues of granularity and breadth apply here.

 

The risk systems should have the capability to alert the proper manager when preset conditions occur so that proactive risk management can occur. The firm should set up a variety (as many as needed) of risk conditions that different managers are concerned with. These conditions should also be set in a variety of ways. The parties could set up criteria that will generate alerts. The relevant manager could then drill down into the alert to investigate further. The proper action could be taken.

For example, a B/D could set these alerts to show limit utilization above a certain level (e.g., 75%) and by security, currency, counterparty, trading ledger, industry or geographic location. The system alerts the appropriate level(s) of management when the condition is met. The alerts should also happen as a result of a what-if or scenario analysis, alerting the appropriate party to what could happen under certain conditions. For example, an alert could occur if a major market move would cause an X% loss in a particular security. Management can then examine the alert and take appropriate action, if any. These alerts are set by management and should reflect the conditions with which management is currently concerned.

For a retail operation, this would include all the above. It would also need to include alerts at the account level such as a big trade or an account that is utilizing an increasing portion of its credit and is heading toward a potential margin call. For example, an alert could occur if an X% market move would cause a margin call in a large (or small) account(s). Management can set up appropriate conditions for accounts it wishes to monitor and be alerted when those conditions are met. Management can then examine further and take the appropriate action, if any.

In addition to all the reports and alerts, managers must effectively communicate with each other so that they are aware of current conditions.

 

 

Risk Management

 

The first two steps in the process provide the analytics and the tools that managers at all levels must have in order to make effective decisions regarding risks. The final step in the process may be the simplest to explain. After all the risks that can be measured are monitored (those that can be measured. Not all risks can be measured and you should not try!), and after the correct monitoring systems and procedures are in place, the final step in the process is actually managing the risk. This simply means management decision-making when called for, based on the information that is available. Managers at every level must be ready to take appropriate actions when a condition exists that warrants attention. This means proactive actions. Remember that not every risk condition or situation requires action. It possible that, for example, that a limit is exceeded on a trading floor and management becomes aware of it. After reviewing the excess, determining the cause and discussing the possible harm, the appropriate managers may let it stand and take no action. Or, an alert can be generated on a specific account. After drill down and review, management decides no action is called for.

 

Some of the critical aspects of managing risk effectively are:

 

The proper analytical tools must be used so that the information to decide possible courses of action is reliable

The proper risk monitoring capabilities, including alerting capabilities that provide this information on a real time basis, must be in place

A risk-oriented mindset must exist in all employees. Senior management must drive this mindset from the top down. Everyone bears some of the responsibility, not just management and risk managers

A willingness to be proactive regarding risk management, treating risk management as a business partner, not simply part of a compliance function

 

Conclusion

 

As we all know, there are many crucial aspects to implementing effective risk management capabilities at a firm. It is critical that each phase be implemented at any firm that wishes to effectively manage its risks. This can be summarized relatively simply. The tools for measuring risk must be accurate as must be the inputs to those tools. This means models must be accurate. Data must be clean. The technology behind the system should help the risk management process by identifying risk so that managers gave increased resources for managing risks. Real-time capability is required; batch processes won’t cut it any more. The outputs of the risk measurement process must be available on a real time basis so that managers understand what is happening as it is happening and can take appropriate action. This means everyone gets the info when they need it. Systems that inform management of current conditions go a long way to helping the process. Finally, everyone should consider risk management as part of his or her job. Effective risk management is possible when these conditions are met.

 

 

J P Morgan Deviated From Original Strategy

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J P Morgan Could Not Stick To The Original Plan. Fear and Greed Replaced Calculated Risk Taking. A Financial Disaster Was Inevitable. See Dimon’s comments.
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