Exploring the Global Financial Information Superhighway

Vol. 11: Construction Period of Offshoring and Outsourcing in the Investment Banking Industry (part four)

Consulting Fellow, RIETI

In 1995, Microsoft Corporation brought Windows 95 to the PC market, as a successor to its earlier operating system (OS) Windows 3.1. The release of Windows 95 in turn produced explosive growth in the number of Internet users worldwide. In international finance, a dramatic paradigm shift began in response to the global trend toward the formation of information system networks. This paradigm shift went on to change the "risk awareness" at the foundation of the financial business. In this volume, we consider one incident that took place in Singapore, a key player in the Asian financial market, the downfall of a traditional international financial institution that accompanied this incident, and increased interest in operational risk.

Barings Bank bankruptcy

As explained in volume 8 (Note 1), and citing comments by Kazuo Mizuno (Note 2), 1995 is viewed as the year in which the dramatic paradigm shift in global information system management in the investment banking industry began. Three major events took place in Japan in the first half of 1995. The first was the major earthquake that struck Kobe in January. The second was the sarin gas attack on Tokyo subways in March. The third was the peaking of the yen against the dollar in April (when it reached ¥79.75 to the dollar).

In that same year, 1995, a news story that shook the international financial markets came out of Singapore, a country whose national strategies we analyzed in the previous installment (Note 3) in this series. According to the story, Barings Bank, a British financial institution founded in 1762, had failed and closed its doors after about 230 years. The cause of the failure was an enormous loss created by a single derivatives trader. This trader mainly traded in Nikkei 225 futures and options on the Singapore International Monetary Exchange (SIMEX), the forerunner to the present Singapore Monetary Exchange (SME), and the Osaka Securities Exchange.

The market moved in a direction opposite to his forecasts, and led to enormous losses. But also deeply linked to these losses was the complex, spaghetti-like structure of information systems and the morass of paperwork processes found at the back office of investment banks, which we have explained through the course of this series. Before joining Barings Bank, this derivatives trader had studied business flows at a back-office processing department, by settling accounts related to futures and options trading in the back office of another investment bank based in the United States for about two years from 1987.

In 1989, this trader moved to the front office after finding a job at Barings Bank. He began to generate enormous profits in the markets for derivatives trading in Japanese share futures and options, which were booming at the time. His derivatives trading positions began to increase in step with the profits. Starting 1992, however, his accounts began to produce losses. The trader sought to cover his losses by using the knowledge he had gained through his previous back-office work. The losses remained hidden for a long time, but mounted because of his cover-up operations. Ultimately, the cover-up became impossible to maintain, and ended with the gyrations in the Japanese equities markets that followed in the wake of the Kobe earthquake in January 1995. By February, the following month, this venerable and world-renowned institution had collapsed, for the unprecedented reason of losses generated by just a single trader (Note 4).

Subsequently, Barings Bank was bought by ING, a major Dutch financial group with international financial operations in dozens of countries around the globe, and which was built on insurance and postal savings. With this incident as the turning point, the financial sector began to attach great importance to operational risk management as one of its key business challenges.

Bank for International Settlements and Basel Committee on Banking Supervision

In the following section, we analyze changes in the awareness for risks in general involving financial institutions, in the context of the histories, positioning, and activities of two organizations based in Basel, Switzerland: the Bank for International Settlements (BIS) and the Basel Committee on Banking Supervision (BCBS).

BIS was established in 1930 as a financial institution to administer the reparations being paid by Germany after its defeat in World War I. BIS continued to administer war reparations, the objective for which it had been established, during World War II. With the inauguration of the Bretton Woods System, based on agreements signed in 1944 and introduced in 1945 just as the war was ending, work began on building an international framework for financial management with the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD) at the center. Under this system, questions were raised about the viability of the BIS, since its scope of activities would be limited. However, the decision was made to retain the bank, at the strong behest of the central banks of European countries.

Later, under the Cold War structure, the BIS became one of the few places where the heads of central banks from the eastern and western blocs could meet face to face and engage in a meaningful dialog. BIS also served as an important forum for exchange over the course of half a century of discussions on the economic integration of Europe, which produced the European Payments Union (EPU) in 1950, its successor, the European Monetary Agreement (EMA) in 1958, the European Monetary System (EMS) in 1979, and finally the European Monetary Union (EMU) in 1999.

The Basel Committee on Banking Supervision (BCBS), popularly known as the Basel Committee, was established at a meeting of the central bank governors of the G-10 Western countries in 1975, about 15 years before a thawing of the ideological confrontation between east and west. A total of 10 countries, including the United States and Canada from North America, Britain, France, West Germany, Italy, the Netherlands, Belgium and Sweden from Europe, and Japan from Asia, took part in the establishment of the Basel Committee. Three additional European countries--Switzerland, Luxembourg and Spain--joined the Committee later. Today, the central bank governors of 13 nations comprise the Committee.

The Basel Committee operates under the basic principles of having no authority of a public nature and its decisions are not legally binding. The Committee instead aims to develop broad supervisory standards and guidelines for the management of risks involved in international finance, based on agreements among participating countries. The Basel Committee expects the participating nations to make every effort to introduce control regulations agreed on by the Committee, bearing in mind their domestic monetary economic circumstances (Note 5).

Operational risks and Basel II

In 1988, the Basel Committee participants produced the Basel Capital Accord, known in Japan as the BIS regulations, with a focus on credit risks to set a precedent for international standards for control regulations that apply to the risks that financial institutions confront. Later, these regulations grew and expanded into the New Basel Capital Accord, abbreviated as Basel II and known in Japan as the new BIS regulations, which added market risks and operational risks to their scope of application.

As explained in the second (Note 6) and third reports (Note 7) in this series, financial transactions across national borders steadily gathered momentum from the early-1980s. The risk of a single financial institution collapse spreading repercussions worldwide became widely acknowledged in 1984 with the collapse of a major U.S. financial institution that had engaged in international financing.

Based on this increased awareness, ways were sought to measure the soundness of the management of financial institutions undertaking international operations for the purpose of building a mechanism for preventing a chain of global-scale bankruptcies in international financial markets. Until that point, many financial institutions that had failed had had a low "capital adequacy ratio," which is the ratio of shareholders' equity to total assets. Noting this tendency, the Basel Committee set unified international standards requiring banks to maintain their capital adequacy ratio at 8% or above for international operations and at 4% or above for purely domestic operations. These standards constituted an accord reached in 1988, which is known in Japan as the BIS regulations.

As explained above, the BIS regulations started from the perspective of "credit risks." Credit risks are also known as default risks or bad debt risks. They refer to uncertainty about the accrual of losses in the balance sheets of financial institutions that emerges when the institutions' receivables become impossible to recover as a result of a deterioration of the finances of their business partners. In addition to these risks, the Basel Committee began to take "market risks" into consideration. Market risks are also known as price volatility risks. They refer to uncertainty about the accrual of losses on the balance sheets of financial institutions that emerges when the market value of financial products owned by the institutions, including securities, changes in response to fluctuations in financial markets.

Taking a further step, the Basel Committee began analyzing "operational risks" in view of cases of collapse, including the case of Barings Bank explained at the beginning of this report. Operational risks are defined as, "the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events." Operational risks are also known as basic risks. They refer to uncertainty that exists across a corporate organization, including uncertainty about administrative errors, fraud and non-compliance by corporate insiders, information system malfunctions, and loss of corporate reputation due to rumors. In other words, operational risk is a generic term for all risks, excluding credit risks and market risks. This category consists of not only administrative and information system risks, but also a broad range of other risks, including legal affairs risks, reputational risks, disaster risks, and country risks.

In September 1998, the Basel Committee prepared an early-phase report titled "Operational Risk Management (Note 8)." As a result of sustained discussions that followed this report, the Committee reached a final agreement on Basel II, which specifies the operational risk quantification method and the classification of operational risks that cause losses, in 2004. The accord was introduced in 2007. As already mentioned, the Basel Committee framework for managing credit risks, market risks and operational risks has changed in the waves of globalization and informatization, which international financial businesses confronted.

How investment banks position and respond to operational risks

In the following section, we consider how investment banks, the focus of this report, position and respond to operational risks, from the perspectives of organizational structure and information systems.

As mentioned in the first volume (Note 9) of this series, the front office is at the top level of the organizational structure of an investment bank. The front office is the profit center of the investment bank. The middle office at the middle level manages risks involved in financial transactions undertaken by the front office. The back office at the bottom level engages in tasks such as account management, transaction reporting, delivery settlement, periodic reporting, accounting, tax affairs, legal affairs, personnel affairs, audit, compliance, and information security. This is a structure typical to investment banks. Within this structure, the middle office centrally manages "credit risks" and "market risks," by focusing on counterparties to financial transactions and on the commodities involved in the transactions, respectively. However, operational risk factors are dispersed across the board in the front, middle, and back offices because such risks are defined as "all risks other than credit risks and market risks."

As discussed in the second (Note 6) and third volumes (Note 7) of this series, the information system structure of an investment bank has a product master for managing the attributes of financial products, including shares, bonds, and futures, a customer master for managing the attributes of transaction counterparties, and functions for producing and recording financial transaction data at the top level. Functions for managing positions and settling cash and securities lie at the middle level. Functions for corporate actions, accounting, and the production of regulatory reports and legal documents exist at the bottom level. In this information system structure, the middle office centrally manages "credit risks" involving the counterparties to front office transactions, and "market risks" involving commodities handled by the front office, based on the customer master data and product master data at the top level, respectively. However, operational risks are dispersed across all three levels, including all information system functions, interfaces between the functions, and manual back-office processing.

In the ways described above, operational risk factors for coverage at investment banks are dispersed company-wide from the perspectives of both organizational structure and information systems. Risk scenarios that give rise to operational risks are wide-ranging and complex for this reason. The investment banking industry had been hard pressed to respond to issues such as the sweeping changes that took place in information systems starting 1995, the European Monetary Union (EMU) in 1998, and the Y2K computer problem in 1999. To meet these requirements, many investment banks set up a provisional section within their back-office processing department to standardize control methods for operational risks that had lagged behind such methods for credit risks and market risks. The banks assigned the section with one task: collecting information about competing investment banks.

Dealing with operational risks became an urgent issue for the financial industry in the aftermath of the September 11 terrorist attacks. As described earlier, in 2004, the Basel Committee adopted Basel II, which standardized quantification methods and classified causes of losses. Through the course of producing the Basel II agreement, concepts such as disaster recovery (DR), business continuity planning (BCP) and business continuity management (BCM) were established. In a parallel development, an increasing number of investment banks set up an independent section for company-wide monitoring of operational risks. This point is examined in more detail in the next report.

The next volume looks at another framework for international cooperation established in Switzerland in 1995, and analyzes Asia, a region pitching and rolling in an air pocket as global credit expansion continues.

July 1, 2008
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  2. Mizuno, K. (2007) Hitobito ha naze global keizai no honshitsu wo miayamaru no ka [Why do people misread the essence of the global economy?], Nikkei Publishing Inc.
  3. Matsumoto, H. (2008) "Construction Period for Offshoring and Outsourcing in the Investment Banking Industry (part three)," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 10, June 8, 2008
  4. Leeson N. (1997) "Rogue Trader," Time Warner Paperbacks: New Edition, ISBN: 9780751517088
  5. Bank for International Settlement (2008), "About BIS," http://www.bis.org
  6. Matsumoto, H. (2007) "Initial Period of Offshoring and Outsourcing in the Investment Banking Industry," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 2, October 31, 2007.
  7. Matsumoto, H. (2007) "Dawn Period of Offshoring and Outsourcing in the Investment Banking Industry (part one)," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 3, November 22, 2007.
  8. Basel Committee on Banking Supervision (1998), "Operational Risk Management," http://www.bis.org/publ
  9. Matsumoto, H. (2007) "Investment Banks as a Global Financial Information Superhighway," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 1, October 10, 2007.

July 1, 2008

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