Home, first-time buyers, mortgages

INSTINCT VERSUS ABILITY

The finance industry’s basic instinct focuses on hiring the best performing stars, and that may include closing eyes to certain work or character defects. One error is that the “star” bank trader or fund manager is really a shooting-star, one that burns up and disappears from sight. Empirical results show that there is only a tiny core of fund managers who are truly stars. These stars are surrounded by the ephemeral satellites who will slip down the market performance stakes. Hiring these satellites at their peak is to risk underperformance, and even fund losses. Reputational risk is once again means sticking your neck on the block. Banks that realise this stand a better chance of succeeding because their risk perception is correct. Investment banks that held on to a large staff with high salaries and higher bonuses in a down- turn put their balance sheets on the line. Those that shed staff and cut payroll fast put their reputation at danger, being seen as a “bank with a problem”, but their financial strength remains.
Mortgage banks that lend money out at low interest rates and high leverage are in this market risk scenario on a different playing field. The fact that the loan is secured on collateral (the property) may be irrelevant – the real estate value can have dived disastrously. “No problem, we can always redo the property.”
The American early 1980s S&L banking failures underlined the danger of such lax risk perception. We have to adopt realistic risk attitudes about the finance game.
The use of RAROC to test individual lines comes across as a good start to justify the investment. RAROC enables a company to ask if it is really making an acceptable return for the risk from each particular business line. It is a fundamental question that is worth asking whether to:

• remove (reduce capital)
• reinforce (more capital)
• stay in the business line
• or get out of the business.

The financial regulatory authorities hope that Basel II will eventually force banks and financial companies to report real trading losses. RAROC and similar tools are designed to develop richer profit and loss accounts, not cosmetic trading figures to appease the regulators and shareholders.
One of the problems that bedevil banks and funds is the uneven standards of institutional practices. The media have tended to focus so far on fraud and rogue trading, even when this is in the minority of losses. The FSA and London Stock Exchange warns that “previous performance is not a guarantee of future . . . ”
Yet, we are constantly faced with inspecting the value of the track record; poor traders or managers continue where they are protected by the mantra of their previous performance. These professionals have prided themselves upon their skill in recruitment and due diligence, their greater ability to sift out between good and unacceptable customers or staff. Unfortunately, banks’ hiring and due diligence errors have subjected them and their shareholders to significant operational and reputational losses that have financial costs. The Basel Committee reported deficiencies in international banking due diligence know-your-customer (KYC) policies. KYC policies in some countries have significant gaps and in others they are non-existent. Even among countries with well-developed financial markets, the extent of KYC robustness varies.
Thus, the Western economies with a long history of developed banking sectors also have large room or exposure for due diligence errors. This risk needs to be rectified.