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The hidden problems and clues
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Lets begin with cultural changes going on in the marketplace. We have seen an exportation of the culture of the highly leveraged trading room throughout the world. The culture of heavy handed risk management has not always been taken with it and you cannot have one without the other. One must ask whether the culture of Sumitomo has been or can be consistent with the culture of a trading room using high leverage. And do they have or can they develop a heavy handed risk management style.
Not only Sumitomo is facing this question. Certainly regulators are facing a new cultural challenge. This begs the question whether they have the proper hands on culture to provide a balance in the new environment.
Next, the markets have become increasingly complex and are beyond the ability of many senior managers to comprehend without more training. It is not, however, only a question of training, complexity has become stylish and traders know it can be used to get pay or power. It can be used to prevent questions from being asked by intimidation. How will Sumitomo and the market deal with this new cultural reality?
Lastly, there is a reduction in the market's ability to price accurately due to the surge in new and over the counter instruments. Firms are relying more on judgment. How do these firms establish a culture to control these judgments being made?
Systems of incentives Moving on to the second topic of the model, we look at systems of incentives. Sumitomo must examine whether their compensation policies played a role. Hamanaka does not appear to have been highly paid but perhaps he substituted power as a form of compensation to make up for low pay relative to industry peers.
Sumitomo must also examine human resources policies to see why an employee would be permitted to work without sleep or holidays. And Human Resources must now deal with the real risk of turnover of their best people.
Next, the market overall faces a skill challenge in risk management. People in this field are usually underpaid. Will Sumitomo and others hire qualified people to manage these risks?
Last in the category of incentives is the pay inversion problem. Are banks, for example, paying lower level employees more than upper level employees and creating an undesirable risk appetite. Are there incentives to take more risk than your boss? How should this be dealt with?
Market and company structures Turning now to topic three of the model, market and company structures, we must look for conflicts of interest between acting on behalf of a customer and trading in the same market. This is particularly problematic in markets that are small, highly concentrated and where information has value. It is not only a question of front running. Brokerage companies need to examine whether they can really act solely in their customer's interest if they have a large position. What role did this play and how should it be regulated?
Next, Sumitomo must look at its structures. Does the communication structure create barriers? They should look at their power structure to see who has it and whether these people deserve it. Perhaps power bears little resemblance to the structural chart.
Legal structures plague the regulatory picture. jurisdictional problems, decisions about what to share, differences in what can be shared, turf questions, and cultural differences all present dilemmas. These may have delayed action by the regulators.
Lastly many people must develop a legal structure around their risk of being sued. Sumitomo must determine the company's posture. Related to this is the problem of controlling Hamanaka. There are probably a dozen ways he could tell this story and still tell the truth; they cannot afford to lose his loyalty.
Total leverage Part four of the model covers leverage. Risks in firms are becoming less transparent despite efforts to increase reporting requirements. This usually means they are becoming more leveraged. Are the organizations involved prepared to spend the huge time and money developing measurement systems to assess accurate leverage. Do they have systems to assess leverage risk from feedback producing positions like options. And are the costs of doing this being assigned properly or are these activities being subsidized? Did Sumitomo or do they now understand how to manage double or triple leverage?
Also, the climate has shifted to easier access to debt through a number of mechanisms. Are these firms prepared to spend the time and money to assess their real debt exposures? Do they understand how to define debt now and how to use liquidity to manage it? Many do not and many do not know who in the firm is actually in control of the leverage and debt now that traders have such easy access to it. Sumitomo must address this or stop using derivatives to generate debt.
Limits The fifth area of the model is limits. Sumitomo faces a number of problems. Will a new copper trader be brought in at Sumitomo? Who would want this job? How will they decide what volume of trade is appropriate for them now? How will they determine whom they want to trade with and how will they limit volume per broker.
What system of surveillance will be used once the accounting firms have looked over their basic accounting controls. Sumitomo must face all of these problems to just keep their current copper positions. Regulators and exchanges face questions about position limits as well as limits on the use of credit to trade. This source of leverage on a leveraged instrument must be examined carefully. And where it is being done on option shorts, there is a need to examine triple leverage.
Liquidity
Sixth in our model is liquidity. Every organization involved must examine whether they should place greater liquidity requirements on assets that have greater complexity. This would punish them for their illiquidity in times of crisis and recognize the market's inability to absorb them. If Sumitomo had such a system it would have discouraged the use of complex transactions.
The banks will need to examine what impact illiquid forms of lending should have on their pricing to their customers. Are they being paid enough to take credit risks using these instruments?
Policies and procedures Last in our model is procedures. Notice that this is where most people would start. But no amount of procedures can solve the kinds of problems that have been raised. Still basic procedures are essential.
In Sumitomo accounting controls seem weak. The policies and their enforcement may be behind it. Perhaps, as is often the case, the policies or the lack of enforcement encourages the cultural dominance of support functions. Maybe the accountants simply did not follow the procedures.
Trade authorizations are problematic but now they must determine from their records what is in place to defend themselves. Do they have this adequate record keeping systems and their backups. Can they even find all the documents and is there a system in place to prevent purging of evidence.
Turning to regulation, the market is asking whether there is adequate reporting. Behind this is the question of whether any amount of informal ton wi 'II be enough to permit regulators to prove their cases in court. It seems regulators face a bigger challenge getting proof than in getting enough information to know a corner when they see one.
This list of deeper problems is just the tip of the iceberg, but in the interest of time I have tried to give you the more important questions that need to be asked and a model for doing so that I have found useful. It has been my experience that without a structured process such as this, most of the problems are never seen and remain unsolved.
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