Climate change and liquidity crises – do our risk scenarios need adjustment?

Toronto/London/New York - 1 November 2007

This month’s Algo FIRST newsletter concludes that risk scenarios need to incorporate the entirety of the human condition, including environmental factors and that more attention needs to be paid to the robustness of risk scenarios to volatile times.

This resulted from the confluence of a number of environmental events – the evacuation of over one million people in Southern California as a result of fire, drought conditions in the Southwest of the US and Southern Europe and increased rainfall in Northern Europe – combined with a near shut-down in the wholesale lending sector and extremely volatile market conditions.

Penny Cagan, a Managing Director at Algorithmics, said, ‘We have identified what we consider to be key risks that are impacting our working environment and have provided excerpts from cases in the FIRST database to demonstrate how large their direct and indirect impact can be. We have chosen cases that have unusual characteristics that might not be considered during the process of imagining what could go wrong.’

For instance the ongoing credit crisis continues to impact operating environments within the financial services sector. One example is provided by an Italian leasing company, which had a lucrative business offering customers fixed interest rate contracts. The company used mirror contracts to hedge derivatives position through interest rate swaps with a number of Italian and international banks. This strategy eliminated its market risk but nevertheless left the company exposed to counterparty, or default risk by its customers. At the end of July, the company paid out 338 million euros to close derivatives positions for a trading loss of 686 million euros and the Italian Central Bank took the unprecedented action of ordering the directors and auditors of the company to quit.

Global warming and significant environmental change are two more external risk scenarios that need to be considered. On October 23rd the Insurance Information Institute estimated that the cost to homes and businesses resulting from the fires in Southern California would be at least half a billion dollars in insurable losses. In addition, San Diego County is expected to face a bill of at least $1 billion. Businesses that are impacted by these types of circumstances, or could be impacted by similar circumstances in the future, should develop scenarios that account for employees who may have lost their homes or cannot get to work.

Terrorism is another constant threat that is now a way of life. In preparing scenarios for the possibility of terrorist attacks Algorithmics often recommends a review of how banks and securities firms located in downtown Manhattan responded to the events of September 11, 2001. In addition, fraud can occur in the aftermath of tragedy as illustrated by the recent case against a former securities broker who was charged in a scheme to defraud the widow of a Port Authority police officer.

Regulatory attention can also have a significant impact on operational risk. For instance the UK Office of Fair Trading (OFT) announced in September 2006 that it would look into default charges on bank overdrafts. Banks have consequently reported a large rise in the number of consumers downloading template letters from their website in order to reclaim fees worth billions of pounds for unauthorized overdrafts. The2007 interim results for the top five UK high street banks indicated that in aggregate they have refunded over £400 million to customers so far. This is in comparison with OFT estimates that the banks are making between £2 billion and £3.5 billion annually from the penalty fees levied when account-holders exceed their authorized overdraft limit. A High Court test case ruling is now being sought aimed at resolving the uncertainty over ‘illegal’ bank penalty charges; the trial is scheduled to start next January.

One more risk that needs to be considered is that of a significant shift in global economic power, as the influence of large emerging economies such as India and China changes how companies conduct business in Asia. This may require an associated shift in risk scenarios developed to account for overseas activities. For instance, risk profiles should account for the possibility that the government of China could pull away from Capitalism in the future and seize foreign assets.

Penny Cagan added, ‘It is not too difficult to imagine a pulling back from the government in China one day and risk scenarios should at least include this possibility. This has been witnessed in Russia when the government pulled back oil company assets that it had previously privatized by saying it was making amends for flawed privatizations that had occurred in the early 1990s.’

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