Twenty Third Floor
Technical Business Advantage

Jérôme Kerviel, a 31 year-old banker at Soc Gen is blamed for losses of €4.9 billion incurred through rogue trades spanning over a period of some months.

The story has a remarkable similarity to Nick Leeson, the Original Rogue Trader who is blamed for the demise of Barings Bank in 1995. Unfortunately for Soc Gen, it seems the comparison extends as well to the general failure of controls and systemic failure of risk management processes. In Nick Leeson’s book (a very worthwhile read) he outlines the astonishing story of how easy it was to do the unthinkable and crater an unfillable hole in Barings’ balance sheet from a trading operation in Singapore without troubling internal controls and external auditors.

Conspiracy

Jérôme was trading vanilla equity derivatives – the sort of things that haven’t been complicated for a long while now. Very similar (again) to the instruments used by Nick Leeson. Jérôme’s positions were supposed to be externally hedged. Soc Gen should not have been exposed to overall delta risk of the markets moving either way. The fact that this was possible, went on for several months, and managed to grow to a hole this size leads some to simply disbelieve the story. One regularly repeated story is that Soc Gen may have incurred higher than tolerable losses (Sub Prime is often the assumed cause here) and needed a scapegoat (answering to the name of Jérôme) to divert blame from senior management.

I have no information as to whether this is true or not and do not want to express an opinion on such a flammable topic!

Stand Up, Internal Audit & Risk Management

Internal Audit and Risk Management areas are often the poor second cousins of the fiancial services world. They have little of the glamour and large bonuses of traders and investment bankers. The “people who make the money” alternate between complaining about the restrictions placed upon them by risk management, and generally feeling superior in every way to the internal auditors.

However, there are many more stories (on all different scales) of internal audit and risk management functions not being strong enough, or following process too rigorously at the expense of truly searching for risks. In fairness to process, I can think of plenty of examples I’ve seen myself where the problems arose from not following process. Businesses need to find a way to ensure adequate protections and controls are in place, without stifling the busines goals of the company. This post is not a comprehensive treatment of what could have fixed the Soc Gen problems, and I’m fully aware of how much easier it is to find the solutions to past problems. Having said that, three general rules for risk management and internal audit that seem not to have been applied here:

1. It seems that Jérôme’s verbal skills may have sidetracked earlier attempts to catch his unauthorised trades. Some hard-and-fast rules are required. No negotiation. You hit this limit, perform this action, make this error and the wheels turn. NASA’s shuttle tragedies have been partially blamed on management’s gung-ho attitude of ignoring engineering warnings. These rules must be made before specific circumstances arise. No exceptions. No special cases.
2. Follow the cash. Jérôme had seemingly faked hedging positions. As he was needing to place variation margin (cash) up for his losses, there should have been hard cash coming on from the offsetting contract. Barings was flushing cash at Nick Leeson’s Singapore operation when half a thought would have raised alarm bells.
3. Reluctance to take leave. Jérôme apparently hadn’t taken leave in 8 months and didn’t let other traders cover his positions. I know a story about a claims processor at an insurance company who hadn’t taken a day of leave in several years. Until he was so sick he was admitted to hospital. That was the day his colleagues figured out he had been paying fraudlent claims to himself for years. There are thousands examples like this. All internal auditors should have read case studies such as these.

Operational Risk

The real story here extends far beyond Soc Gen’s borders, beyond Frances and beyond the investment banking world. Companies of every size are exposed to a range of risks, some identified and measured, others Black Swans waiting to make a first entrance.

Operational Risk, defined by the Basel committee as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events”. These losses are an excellent (although extreme) example of op risk. Operational risk is more difficult to measure than many other types of risk. The actual events that give rise to the biggest risks are often unique. Past experience at Soc Gen would not have indicated that a risk of this type and magnitude were possible.

Before the Barings disaster, few would have imagined that such an event were possible. It would have been excluded from “reasonable” risk management discussions and measurements as too unlikely. After 1995, when many banks realised that there previous understanding of how badly things could go was wrong, better risk management systems and controls were implemented. From the responses of many in the industry, it appears as if everyone was again under the impression that this magnitude of risk couldn’t happen. Now, in a little over ten years, we’ve had two events of similar style and broadly comparable scale.

The real question isn’t when will something like this happen again. The question is what will be the next completely unexpected op risk event be?

Business Report has an interesting article where Eskom recommends shelving new infrastructure projects due to lack of electricity until at least 2013. A few important quotes form the piece:

Bongani Nqwababa, Eskom’s finance director, said yesterday that the parastatal had advised the government that it wanted South Africa marketed only from 2013 for both local and foreign projects[....]  Eskom had not formally advised the department not to approve big industrial projects until 2013.

Which is slightly odd in itself – Eskom offering informal advice around electricity supply?

Eskom’s initial planning was based on 2.3 percent annual growth in demand for electricity. But this was revised to 4 percent when the government set a 6 percent economic growth target. Last year electricity demand grew 4.9 percent. In the year to March, growth is expected to reach 4.3 percent.

Three things strike me here:

1. These demand growth assumptions seem to assume fairly substantial improvements in energy efficiency, assuming that as people become wealthier they won’t install air-conditioning in their houses and purchase more appliances, that offices won’t use more high-tech equipment pulling down Kws at every opportunity. I wish we had a graph of electricity consumption vs GDP.
2. A few years of economic growth above the plan meant rolling black-outs? This sounds unlikely. I can imagine that the buffer would have shrunk, but not to the extent that is has. Also, as the buffer was shrinking, wouldn’t that be the first signal to up production, given the long time to get projects on stream?
3. And if it really is a combination of higher than expected  growth and bad luck with Koeberg faults, power line problems etc. then surely this implies that the buffer chosen was too small? It doesn’t take an actuary to know that uncertain, dependent time-series processes (such as demand for electricity) can run away quite quickly. The more variation and dependency, the greater  the risk that the series (demand) will breach some bound (maximum sustainable supply). I’m sure that Eskom has a few engineers floating around and this stuff should be right up their alley.

If we add in the growth in residential housing developments, and the industrial infrastructure projects underway and planned (e.g. Coega) then the deterministic demand projections look on the low side to start with, and take no account of variation in this rate. If anyone at Eskom is listening, I’ll happily work with them to build a simulation model to determine what the appropriate size of the buffer really is.

Update:
A few more bits of information from an article written by Anton Eberhard from the UCT Graduate Business School

Annual peak demand has grown on average by just over 3.6 % per annum since 2000. Current peak electricity demand is actually lower than that predicted in Eskom’s Integrated Strategic Electricity Plans that were prepared in 2001, 2003 and 2005. Electricity forecasts have been reasonably accurate.

Furthermore, as far back as 1998, the Energy Policy White Paper warned of supply shortages around 2007.The claim that electricity demand has grown faster than predicted – and that this accounts for current supply deficits – is not supported by the data.

[...]

In 2001 Eskom was actually prohibited by government from building new generation capacity. Despite this embargo on Eskom, no concrete steps were taken for alternatives.

Interesting, yes?

South Africans have been lamenting the state of our power infrastructure and Eskom’s inability to keep infrastructure up with demand.  Now there’s plenty of useful debate left there (so many of the points I hear made are irrelevant and serve to distract everyone from the real issues.

Past sins

For example, why are so few people pointing to the previous Eskom tariff increases – the requested increases haven’t been granted in recent history (my quick search confirms this for several years, but my search wasn’t exhaustive). In general, the increaes have been below CPI, CPIX, PPI and, recently anyway, the actual cost of generating electricty given operating costs and the rising costs of the fossil fuels required.

The problems revolve around three factors:

1. The tariff increases granted have been officially based on a regulator-approved return for Eskom.
2. Eskom has been reducing its debt as a direct result of the reduced capital investment. The increased cash generation has been used to reduce debt levels. How this reduction in debt has been figured into the required return for Eskom (allowing for the reduced gearing usually implying a lower required return), or their operating costs (interest payments included in required return calculations or not) is not clear.
3. Presumably the required return calculations made some allowance for either depreciation or future capital replacement costs (let alone the capital required for future capital required for new infrastructure investments, because there is a strong argument that in a truly market-based economy future projects should be met with future revenues – this is not the only option). Given the apparent lack of apreciation for replacement, renewal and reinvestment costs it seems possible that all these careful calculations of the required return are, quite simply, wrong.

The problems in demand do not come from a sudden and completely unexpected increase in economic growth. Until as recently as last year, there was no discussion of the impact that increased economic activity was having on the demand for electricity, and Eksom was granted a particularly low increase (although my reference for this and the exact number temporarily evade me). Lack of appreciation of the underlying economics, a flawed calculation of the required return and the actual return generated allowing for non-cash items have come back to haunt us.

Other sources of enlightenment

Slashdot has a post “California Utilities to Control Thermostats?“ covering a NY Times article on teh same topic. Interesting to read the comments and links to a variety of similar problems and a range of possible solutions. These solutions include WW2 technology used to operate air raid alert sirens and sensors that operate automatically on a decrease in the frequency indicated by strains in load.

The increased interest in nuclear power generation (and perhaps, more importantly, a decreased reluctance to go down the nuclear path) is also clear. A word of caution though: the readers and contributors to slashdot are not necessarily representative of the US population as a whole!

Tragedy of the Commons

What I found encouraging is how many people stated that prices should be increased – as much as nobody likes to pay more for something, the economic reality that Somebody does need to pay for something that has a cost seems more firmly entrenched in that society than our own. Makes me remember the age-old (well, since 1833 anyway and revisited thoroughly truth of the Tragedy of the Commons where finite resources shared by several with inappropriate incentives to moderate consumption are destined to overexploitation.

Financial and risk implications for Eskom and taxpayers

Engineering News has a story: S&P’s may cut Eskom’s ratings outling how Eskom’s planned capital investment, financed mostly with debt (rather than an equity injection from the state) and through long overdue, and lower than required tariff increases, has reduced their capital strength and likelihood of needing a fresh injection of capital in future. The credit rating of a parastal like Eskom is always interesting, since as South African citizens and residents it is difficult to contemplate Eskom defaulting on its obligations to foreign investors without indicating a financial meltdown of the country’s finances as a whole. However, regardless of the quality of Treasury’s implicit guarantee of Eskom’s debt, the “credit watch negative” has clear implications for the future finances and tariff increases in future.

The rolling blackouts will continue. Under the name of load-shedding or less spin-friendly terms.