Second of three parts.
Enron Corp.'s collapse has raised many questions relevant to financial services companies. In part two of a three-part series, American Banker examines whether the losses faced by banking companies such as Citigroup Inc. and J.P. Morgan Chase & Co. illustrate a need for better risk management systems or more disciplined management. Part one asked whether the Gramm-Leach-Bliley Act encouraged excessive risk taking. Thursday's story will address what lies ahead for retirement savings policies.
By Rob Blackwell
WASHINGTON - Of the myriad lessons from the fall of Enron Corp., risk management experts agree that the biggest one may be the simple reminder that human interference can foil the best models.
For one thing, the banks themselves exercise ultimate judgment over every credit decision. For another, every risk management tool remains at the mercy of the financial statements provided by borrowers and approved by auditors - and if those reports are misleading or inaccurate, as was allegedly the case at Enron, the risk models are of dubious value.
"We have models and tools and can do some what-ifs and trend-line analysis but if you are not getting good, reliable information from your client, garbage in truly is garbage out," said William L. Perotti, the chairman of RMA-the Risk Management Association and senior executive vice president of the $8 billion-asset Frost National Bank in San Antonio.
"You have to draw the distinction between risk measurement and risk management," said John Mingo, the managing director of the risk management consulting firm Mingo & Co. and a former Federal Reserve Board risk management expert. "You see all kinds of cases in banking where technical types did a good job of measuring risk, and risk management did a fairly stupid job of using that measurement. The point is: Don't blame us modelers, blame the managers."
But during a conference call to reporters last week, Sanford I. Weill, the chairman and chief executive officer of Citigroup, said that its risk management systems passed the Enron test with flying colors by limiting losses.
"I don't think it shows a flaw in our systems," he said. "The size of our exposure relative to the size of our company is really very, very small."
Asked how Citi would review or alter its systems because of Enron, Mr. Weill said his company is constantly updating the systems and hopes to learn more from the Enron debacle as more information becomes available.
"We are continually reevaluating our systems and risk criteria," said Mr. Weill, who reported Citigroup lost approximately $228 million in the fourth quarter on Enron. "Hopefully, we will continue to upgrade and do a better job. A lot of the facts of Enron have yet to be completely explored. I think we will know more in a year and be able to better answer this question then."
Federal regulators are customarily hesitant to second-guess the moves of specific banks in public, but a veteran regulator who spoke last week on the condition of anonymity generally supported the assertion that the lenders did not take on excessive risk.
Still, asked whether he thought in hindsight that lenders should have known something was wrong at Enron, the regulator said the company's complicated financial statements, with pages of footnotes, should have been a red flag. He also cautioned lenders on the potential risk that another Enron is lurking in their portfolios and waiting to explode.
At a conference call with reporters last week, Marc Shapiro, the Morgan Chase vice chairman who oversees risk, defended his company's credit analysis and insisted that it has a well-balanced portfolio.
"If you look at the overall credit picture, our numbers have been quite good," he said. "And it's important to step back from the one situation of the names that are in the headlines. We deal with a large slice of corporate America, and when it is affected, we're going to be affected by it. But I think, over all, if you look over the course of time - not just this year, but over some extended period over the whole credit cycle - I think you'll find that our credit quality statistics are going to stack up quite well."
The final analysis of the situation will depend on some questions that will not be answered for a long time - and the answers could prompt completely different conclusions.
For instance, maybe the lenders were not as clueless as most assume from the current information. The Securities and Exchange Commission is reportedly exploring whether Morgan Chase or Citigroup was involved in establishing Enron's deceptive networks of business partnerships and knew more than they have let on.
On the other hand, such investigations may turn up nothing, and the lenders' gains from bankruptcy court or other offsets could minimize the damage and justify the risks associated with such loans.
Regardless of the answers, most risk modelers said that financial institutions were going back to their systems to see what could be improved.
"Every institution that has a loss on this is taking another look at their systems, particularly what went wrong and why," said one large bank executive, who spoke on the condition of anonymity. "It makes everybody stop and rethink. That is just a natural part of the system."
Still, many said they were pessimistic about the possibility of improving banks' risk systems. Shaheen Dil, senior vice president and director of portfolio and operational risk analysis for PNC Bank, said there is little defense against improper accounting or poorly constructed financial statements.
The use of additional market indicators would help strengthen a risk management system, she said. "A risk management system is flawed if financial statements are the only thing you use. You have to use those, but they always have to be supplemented with market-based indicators that are more forward looking, and that could predict things before financial indicators."
Certainly, while lawmakers and regulators continue to decry the actions of Enron and its accountant, Andersen, the once obscure topics of disclosures and accounting rules are now on the front burner.
But while some are struggling to improve disclosures without vastly increasing the burden facing companies, sources agreed that many bankers will try to scrutinize reports more carefully for fraud.
In the meantime, Mr. Perotti said, bankers have to try to use their instincts more effectively when evaluating risk, particularly if they have trouble sizing up the borrower.
Though Frost National officials knew some Enron executives, the banking company did not did not extend credit to the energy trader precisely because the bankers did not understand its business, he said.
"Our basic philosophy is that if we don't understand a business, we will not extend credit to it," Mr. Perotti said. "I believe that if something grows like a weed, it probably is."
A cornerstone to any risk management system has to be people who really understand, and have a connection to, the borrower, he said. "There is a tendency to say risk management means models and computers, but there is a human element. People may overlook that.
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