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Moral Hazard The Silent Assassin in Trading Organizations 2nd Annual UH-GEMI Energy Trading and Marketing Conference Houston, Texas January 22, 2004 Dunham.

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Presentation on theme: "Moral Hazard The Silent Assassin in Trading Organizations 2nd Annual UH-GEMI Energy Trading and Marketing Conference Houston, Texas January 22, 2004 Dunham."— Presentation transcript:

1 Moral Hazard The Silent Assassin in Trading Organizations 2nd Annual UH-GEMI Energy Trading and Marketing Conference Houston, Texas January 22, 2004 Dunham L. Cobb

2 2 Hard Side Risk Oversight Committees Policies & Procedures Risk Assessments Measures and Reporting Risk Limits Audit Processes Systems Risk Literacy People Skills Integrity Incentives Culture and Values Trust and Communication Soft Side The 2 Sides of Risk Control Over the years, thousands of man-hours and tens of $millions will be spent by an organization to detect, manage and mitigate the “hard” side. The “hard” side of risk control is objective and measurable. The “soft” side of risk control is subjective and difficult to measurable.

3 3 InstitutionLossRelated Activities Enron$ Tens of BillionsCorporate Fraud (shareholder equity) Sumitomo$2.6 BillionCopper futures Orange County$1.7 BillionStructured notes Barings$1.4 BillionNikkei futures Metallgesellschaft $1.3 BillionOil futures Daiwa$1.1 BillionUnauthorized bond transactions But “Headline” Events are Consistently on the Soft Side

4 4 InstitutionLossRelated Activities HealthSouth - Scrushy$1.4 Billion ++Corporate Fraud 11 Wall St. Firms$1.4 BillionCorporate Fraud (analyst reports) Tyco - Koslowski $600 million Theft - Swartz NYSE - Grasso$190 Million? Comp package TYCO - Lord$?? millions Undisclosed fees Brown IM Clone - Waksal$?? CEO Insider Trading Rite Aid- Glass$?? CEO Insider Trading Scandal “Hall of Infamy” -- Other

5 5 InstitutionLossRelated Activities Enron$ Tens of BillionsCorporate Fraud (shareholder equity) Sumitomo$2.6 BillionCopper futures Orange County$1.7 BillionStructured notes Barings$1.4 BillionNikkei futures Metallgesellschaft $1.3 BillionOil futures Daiwa$1.1 BillionUnauthorized bond transactions But “Headline” Events are Consistently on the Soft Side Only instance NOT due to moral hazard. …Why are resources so misallocated to the “hard” side?

6 6 Understanding Moral Hazard

7 7 Understanding Moral Hazard Why have attention and resources been so misallocated?  The answer is unfortunately simple: Managing the soft side has been too elusive.  Risk management is rooted in the three M’s—measure, monitor and manage—but those are concepts not easily applied to behavior. However, there are cost-effective ways to mitigate moral hazard if a company is willing to de -mystify the motivation behind it.

8 8 Understanding Moral Hazard Definition: In a business context, moral hazard (MH) is: “The likelihood of the willful commission of an act that is prohibited by the rules of an organization, typically found in its Policies or Procedures handbooks or Code of Ethics.” In a nutshell, MH is the risk that individuals will, by omission or commission, intentionally engage in bad behavior.

9 9 Understanding Moral Hazard Why are trading organizations so fertile for moral hazard?  There is a LOT of money involved. By their very nature, empower employees to transact on the company’s behalf and thus tempt traders to abuse that power What solutions have been considered up to now?  One solution to moral hazard would be to act upon the assertion that sometimes, “the best cure for a disease is to kill its host.” Since it is generally accepted that energy companies should have some trading capability, any cure that would eliminate all trading arguably would be worse than the disease.  Equally impractical, listen in on all deal-maker conversation. This would “drain the coffers”  A more practical approach would be to leverage limited risk management resources in a way that optimizes protection to the organization. Yet how can a company manage something that it can‘t easily detect?

10 10 Understanding Moral Hazard First thing to recognize:  The underpinning of moral hazard is behavior, and behavior is grounded in the axiom: “People do exactly what they are motivated to do.”  To manage behavior, one must model it in a way that reveals its driving incentives and their interrelationships.

11 11 Modeling Moral Hazard

12 12 Reward Penalty Likelihood of Being Successful Likelihood of Being Caught Urgency of Need/Greed Personal Moral Ethic Component A: Risk/Reward Component B: Probability of Success Component C: Personal Inclination Modeling the Risk of Moral Hazard  A model for moral hazard already exists and was used to teach “The Economics of Corruption” at Yale University in the 1970s… MH = The goal in managing MH is to keep the numerator from overwhelming the denominator.

13 13 Modeling the Risk of Moral Hazard In component A (risk/reward)  Rewards act as a catalyst in favor of an act of MH  Rewards include “avoidance of the unwanted”.  Penalties are the consequences of being caught -- reprimand, fine, suspension, dismissal, and/or prosecution – thus are a deterrents to moral hazard  The “reaction” an individual has to a penalty is influenced by two factors:  “Personal Moral Ethic” – for some individuals, even a consequence as light as a reprimand is so distasteful that they will significantly increase their personal weighting of the penalty, greatly decreasing the risk of moral hazard.  Consequences are not “real” enough - Why? Most employees of trading organizations have not suffered seriously as a result of behaving badly, nor have any of their friends. As a result they subconsciously underweight the penalty.

14 14 Modeling the Risk of Moral Hazard In component B (probability of success)  The odds of succeeding and getting caught have an inverse relationship. Any steps that make the improves detection clearly makes it more difficult to get away with it. One’s perception of the likelihood of success is increased by a perpetrator’s familiarity with procedures and IT system capabilities… and especially their gaps and weaknesses. -Perpetrators are usually quite clever  The likelihood of being caught is mostly a function of corporate controls. The likelihood of being caught decreases the higher a perpetrator’s level within an organization because there has traditionally been far less infrastructure providing scrutiny and, let’s face it… They make the rules… and face it, how many whistle blowers are willing to sound off when the police chief is the crook?

15 15 Modeling the Risk of Moral Hazard In component C (individual inclinations), two factors do battle -- a person’s greed/need and moral ethic.  Greed is universal, but more restrained in some people than in others. Need is also universal, but its urgency can be influenced by outside pressures like family tragedy or excessive debt.  Balancing the forces of greed/need is the person’s personal moral ethic, the “wild card” of the model because its range of influence can be so wide. For some people: “A person’s word is their bond” is absolute. For others, it is absolute drivel! For most of us, the influence of personal integrity falls somewhere in between.

16 16 Personal Moral Ethic Reward (risk to organization) Urgency of Need / Greed Penalty (if caught) Likelihood of Being Caught Likelihood of Being Successful Modeling the Risk of Moral Hazard  Factors in the model have wider ranges of influence on one’s behavior than others. The “tornado-chart” below provides a sense of the distribution to which these factors “show up” in a population. Deterrent to Moral HazardIncentive for Moral Hazard Essentially, if the lure of the prize exceeds the sum of the other factors for a given individual, they are likely to succumb

17 17 Reward Penalty Likelihood of Being Successful Likelihood of Being Caught Urgency of Need/Greed Personal Moral Ethic Component A: Risk/Reward Component B: Probability of Success Component C: Personal Inclination Modeling the Risk of Moral Hazard  Some factors have impact on others: “Personal Moral Ethic has the greatest effect, impacting both one’s “Urgency of Greed” as well as the weighting one puts on “Penalty” “Likelihood of success” has an inverse relationship to “Likelihood of being caught”

18 18 ? Penalty Likelihood of Being Successful Likelihood of Being Caught Urgency of Need/Greed Personal Moral Ethic Modeling the Risk of Moral Hazard  The factors of MH have differing degrees of influence on improper behavior. Component A: Risk/Reward Component B: Probability of Success Component C: Personal Inclination

19 19 ? Penalty Likelihood of Being Successful Likelihood of Being Caught Urgency of Need/Greed Personal Moral Ethic Modeling the Risk of Moral Hazard  The factors of MH have differing degrees of influence on improper behavior.  Unfortunately, the “transparency” of these influences are inverse to their impact on behavior. Component A: Risk/Reward Component B: Probability of Success Component C: Personal Inclination Transparency

20 20 Managing Moral Hazard: Where are we now?

21 21 Modeling the Risk of Moral Hazard Perpetrator’s Reward / Victim’s Risk LOW HIGH PILLAGE PILFERAGE Odds of Improper Activity Occurring: No constraints  MH /  Reward

22 22 Modeling the Risk of Moral Hazard LOW HIGH PILLAGE PILFERAGE Resources Spent in Prevention/ Penalty if Caught Odds of Improper Activity Occurring: Add Controls and Penalties Perpetrator’s Reward / Victim’s Risk  MH  Reward

23 23 JOB LEVEL: Regular Trader Direct Performance Bonused Trader C-Level Executive INCENTIVE: Save Job Bigger Bonus Wealth, Power, Prestige Modeling the Risk of Moral Hazard Perpetrator’s Reward / Organization’s Risk LOW HIGH PILLAGE PILFERAGE Odds of Improper Activity Occurring: More Realistic  MH  Reward

24 24 Managing Moral Hazard: Is Sarbanes-Oxley the Answer?

25 25 Moral Hazard and Sarbanes-Oxley  Five Components of COSO Internal Control Framework Control Environment Risk Assessment Control Activities Information and Communication Monitoring

26 26 Moral Hazard and Sarbanes-Oxley  Five Components of COSO Internal Control Framework Control Environment Risk Assessment Control Activities Information and Communication Monitoring Soft Side Hard Side: - Section Section 404

27 27 Managing Moral Hazard: Practical Steps

28 28 Managing Moral Hazard: Practical Steps  “People do exactly what they are motivated to do.”  “It’s easier to ride a horse in the direction it is going.”  “You can’t herd cats… but you can influence them with tuna fish Moral: Make DARN sure that what you want people to do is aligned with what they are motivated to do!

29 29 Personal Moral Ethic Reward (risk to organization) Urgency of Need / Greed Penalty (if caught) Likelihood of Being Caught Likelihood of Being Successful Modeling the Risk of Moral Hazard  Which factors can we directly impact or indirectly influence?  In what order should we attack these factors to achieve maximum leverage? Deterrent to Moral HazardIncentive for Moral Hazard 1

30 30 Methods to Reduce Moral Hazard: 1  Do a better job of screening candidates for employment Companies should make a concerted effort to avoid hiring untrustworthy individuals -A major financial company has statistically demonstrated that inaccuracies on resumes—exaggerations or lies—are very reliable indicators of a low moral ethic.  Hold existing employees to a zero-tolerance standard on tell the truth There is never, ever a valid reason for an employee to withhold or be evasive about information -- much less overtly lie. But… an organization must demonstrate reasonable tolerance for errors. “Anyone who avoids the truth when it’s not important is guaranteed to do so when it is important.”

31 31 Personal Moral Ethic Reward (risk to organization) Urgency of Need / Greed Penalty (if caught) Likelihood of Being Caught Likelihood of Being Successful Modeling the Risk of Moral Hazard  Which factors can we directly impact or indirectly influence?  In what order should we attack these factors to achieve maximum leverage? Deterrent to Moral HazardIncentive for Moral Hazard 2

32 32 Methods to Reduce Moral Hazard: 2  Make penalties seem less remote. The penalties listed in an employee’s handbook are not likely to change, but the employee can be made to take them more seriously. “Do something improper and we will catch you… maybe not today, maybe not even this month, but we will catch you. And when we do, you can count on the following: you will be dismissed, if warranted you will be prosecuted, and to the extent we legally can, we will make it difficult for you to work anywhere else in the industry.”  Enforce the penalties you have. Give Risk Managers real power and authority!! -“Front-officentricity” is a prevalent malaise within many organizations. Because trading is the revenue side – the bread and butter – of an organization, policies are often ignored. °A wink and a nod by management is an invitation to subordinates to view rules as milestones to be passed on the way to an “end justifies the means” goal.  Industry oversight with sharper teeth. The energy industry needs a mechanism—like the securities industry’s— for making competitors and authorities more aware of a miscreant’s misdeeds.

33 33 Personal Moral Ethic Reward (risk to organization) Urgency of Need / Greed Penalty (if caught) Likelihood of Being Caught Likelihood of Being Successful Modeling the Risk of Moral Hazard  Which factors can we directly impact or indirectly influence?  In what order should we attack these factors to achieve maximum leverage? Deterrent to Moral HazardIncentive for Moral Hazard 3

34 34 Methods to Reduce Moral Hazard: 3  Decrease errors Most acts of moral hazard start with a human error that leads the perpetrator to believe, fearing repercussions, that there is nothing to lose by trying to hide their mistake. -Rarely are such individuals driven by visions of Ferraris or Caribbean villas, nor are they typically villainous. -They are average people motivated by the fear of losing their job. Every error that goes undetected through the deal capture and confirmation process is a seed for moral hazard. Detecting and fixing these errors quickly nips incentives for MH in the bud.  “Death by a thousand cuts” But even errors that do NOT lead to moral hazard are expensive -Some organizations have estimated that cumulative cost of small errors can go as high 0.25% of revenues… $2.5 million per billion. Rapid error detection decreases: -Prior Period Adjustments -Trade disputes -Accounting staff

35 35 Personal Moral Ethic Reward (risk to organization) Urgency of Need / Greed Penalty (if caught) Likelihood of Being Caught Likelihood of Being Successful Modeling the Risk of Moral Hazard  Which factors can we directly impact or indirectly influence?  In what order should we attack these factors to achieve maximum leverage? Deterrent to Moral HazardIncentive for Moral Hazard 4

36 36 Methods to Reduce Moral Hazard: 4  Sufficient risk management resources, Senior management must determine the amount of risk they are really willing to accept and resource Risk Managers accordingly “Single Version of the Truth”. Invest in IT data management so that the organization’s business is not being run from numerous un-audited spreadsheets. -Easy to hide trouble in a sea of spreadsheets  … allocated better. Be smart with your resources as they are finite. Pay closer attention to the activity of those most motivated to misbehave (e.g., a trader whose bonus is based on trading profits).  Streamline down to policies and procedures that work and stick to them They should be written in concert with the front office as their ultimate purpose is to increase bottom line. Poorly conceived procedures can promote less compliance! -Substance over form always If a rule doesn’t work, modify or get rid of it.

37 37 Methods to Reduce Moral Hazard: Others  Make sure incentives/objectives are not in conflict across an organization This is an unbelievably prevalent condition and begs people to act improperly  Data quality Most organizations do not have a clue how good their data – particularly deal data – is. -Completeness and accuracy -Many organizations are more interested in timely risk reports than accurate risk reports.  Senior Management often sets earnings objectives at unrealistic levels that almost force trading organizations to break the rules

38 38 Managing Moral Hazard: Getting Started

39 39 Moral Hazard Risk Assessment: Perform a “Rip-Off” Assessment  Looks for gaps/conflicts in: Trading policies and process HR hiring and firing policy Planning and Budgeting Errors Systems -Data -Reporting Skills Governance -Reporting lines Incentives / Objectives Compensation

40 40 Moral Hazard Risk Assessment: Perform a “Rip-Off” Assessment  Output: “Actionable” List of Moral Hazard Flash-points -People, process, system Flashpoint are ranked by: -Frequency -Impact -Cost of mitigation Business case -Suggested remediation plan based on your own risk tolerance and resources to be committed. -Many quick-hits are very inexpensive Ancillary benefits -Fewer trade disputes with counterparties -Fewer Prior Period Adjustments (PPA’s) -Lower overall accounting costs

41 41 Moral Hazard Risk Assessment: Why use my group?  To quote a member of the “Association of Certified Fraud Examiners” (ACFE)… “A person with experience is never at the mercy of a person with a theory. To catch a thief you must be able to think like one. You don’t make a person a lead detective just because they graduated top-of-the-class from criminology school.”  We use people with both trading and risk management backgrounds and the battle scars to prove it.  Every one of us understands the behavior-drivers for MH and how to influence them.  We all know how to game the system.

42 42 InstitutionLoss Impact to Reputation? Enron$ Tens of BillionsPriceless Sumitomo$2.6 BillionPriceless Orange County$1.7 BillionPriceless Barings$1.4 BillionPriceless Daiwa$1.1 BillionPriceless HealthSouth - Scrushy$1.4 Billion ++Priceless 11 Wall St. Firms$1.4 BillionPriceless Tyco - Koslowski $600 million Priceless - Swartz Is it worth it to NOT address MH? …you decide.


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