Saturday, June 28, 2008

Off balance sheet risk

I spent most of last week at Tom Gilb’s seminar on Risk and Uncertainty. Tom expects everyone at this seminar to contribute, so, having heard several very competent speakers present some very thought provoking ideas I was, for the first time in a long time, a little bit nervous about doing my own presentation.

As it was my presentation - entitled Risk, Uncertainty and Money - was well received. Funny thing was, I had a much better understanding of what I was trying to communicate after I finished presenting! I expect a revised version of this session to resurface at some other conference in the near future.

A few days before the seminar I heard about a new risk management technique being employed at one London bank. The bank is asking its suppliers to take on the risk of system development. Nothing new there you might say, the ability to take on such risk is exactly why Logica, EDS, Accenture and co. exists and keep merging - you need a big company, with a big balance sheet to take on these risks.

But this bank had, as I understand it, three novel twists:

• The bank wanted the suppliers to take on the risk of errors made by the system after deployment. Not just the risk of development but the risk of using the system.

• The bank wanted the suppliers to accept unlimited liability - so an insurance policy wasn’t going to be enough.

• The bank was managing this project themselves and the suppliers were not Accenture or Logica or similar but IT contractors. Such contractors are individuals, trading as self-employed professionals or, more usually, limited companies with one employee.

Taken together what this means is: part of the operational risk of building an using the system is now taken by not the bank but by the IT contractors. So, on the bank doesn’t need to carry this on the “risk balance sheet”. If something goes wrong the contractors will pay up.

Except, the contractors are individuals. If the bank comes looking for £10m they aren’t going to be able to pay. The bank could get them declared bankrupt but it isn’t going to get its £10m.

So the bank isn’t off loading the risk, it is still taking the full risk but by a slight of hand it can claim it isn’t. This seems like a dangerous development, the bank are not only deluding themselves but are potentially deluding their investors and regulators about the risks they are taking on.

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