Investment professionals say risk management controls can be improved across the board at financial institutions, although the situation at Barings PLC, London, probably was an extreme case of lax controls.
Barings' unprecedented $1.4 billion loss in futures contracts has financial executives of all stripes questioning the quality of risk management controls in and outside of their firms.
And consultants say investment losses aren't always the first sign of trouble; investment gains sometimes can be just as big a concern. One consultant says pension funds are among the most vulnerable to problems from hidden, excessive risk.
"It kind of wakes you up and makes you realize this can happen to anybody," said Jeremy Dyer, fund manager for Scottish Amicable Investment Managers Ltd., Glasgow, in reference to Baring's speedy collapse.
Likewise, Francis Petrash, senior manager of risk management technology, Coopers & Lybrand, L.L.P., New York, said Barings' losses are "raising the consciousness" of senior managers on risk management controls.
While the bankruptcy of Orange County, Calif., and the collapse of Askin Capital Management raised questions about risk management, those institutions were not viewed to be as sophisticated as Barings, industry participants say.
"Barings was a well-run firm," but apparently didn't have the controls, said William Michaelcheck, who runs Mariner Partners, an investment partnership in New York. "I don't think there's a firm on earth that's not questioning their systems today," he said shortly after Barings' problems came to light.
Based on press reports, consultants say Barings committed some fundamental risk control errors, particularly if both trading and clearance were under the authority of one person.
Segregation of trading and back-office operations is "something an auditor learns in the first week of class," said David Orszulak, a manager for Price Waterhouse L.L.P., in its investment management and securities operations consulting group, Hartford, Conn. Separating the two is done not only to avoid financial disasters - as happened at Barings - but to avoid the temptation to bend the rules, he said.
And one of the first signs of a possible lapse in risk controls might not be a catastrophe on the scale of what happened at Barings.
"I'm as much concerned with someone taking a big win as much as taking a big loss," said Scott Lummer, managing director, Ibbotson Associates, Chicago. It's "actually a more severe problem given human nature," he said. When a strategy or trader makes a lot of money, the tendency is to think more money should have been devoted to the strategy or trader, Mr. Lummer said.
Mr. Orszulak said it should be an "equally egregious offense" to make money stretching investment guidelines as it is to lose money doing so. "A wrong is a wrong," he said.
And to find the next Barings, one could perhaps look to the investors who profited trading against Barings' futures positions.
All the money Barings lost was won by others, and those winnings create the potential to confuse fortunate market movement with investment skill, Mr. Lummer said. On the other side of that billion dollars or so profit, "somewhere there's a 'damn we're good;' That's the next Barings," Mr. Lummer said.
Once a manager or trader starts making more money, guidelines are stretched or ignored the next time around. In these cases, supervisors start thinking the trader is skillful, not just lucky, he said.
And without downplaying what happened to Barings, Mr. Lummer said bigger dangers still lie with non-financial, investing institutions, such as pension funds and corporations.
Financial companies "are going to be, by their very nature, having to take risk," he said. "Trading companies, they make money, they lose money, that's going to happen."
But "most pension plans are probably underestimating the risk they are taking," he said. "We have a lot of concerns."
The number of losses at institutions in 1994 from derivatives is greater than what is known, including at pension funds, Mr. Lummer said.
Nonetheless, all companies can do a better job of managing their risk, given that firms selling derivatives or derivatives strategies are going to downplay possible bad outcomes. "Companies are taking exposures that are being soft-pedaled" by the managers of the assets, Mr. Lummer said.
Some see equity-linked derivatives and derivative strategies as being the next source of unexpected losses. Mr. Michaelcheck of Mariner Partners said the next big test could come with equity-linked derivative products in the United States, where volatility has been very low in recent years. "I think there are a lot of equity derivatives that haven't been tested yet," he said.
To help prevent unexpected positions being taken, consultants said firms have to set various levels of trading limits beginning with each trader all the way up to firmwide limits.
While most firms have set trading limits, too often they are broken when a trader, manager or strategy becomes successful.
Those guidelines should not be broken, Mr. Lummer said. Perhaps guidelines can be changed for experienced traders, but once they are set, "that's the law, no ifs, ands or buts," he said. The key is defining risk, setting guidelines, and not overstepping them.
Moreover, Mr. Petrash of Coopers & Lybrand said traders and their supervisors should meet regularly to discuss the trader's positions and the potential profits and losses, and the risks being taken.
While computer systems can sometimes be cracked, and accounting numbers played with, using personal interaction and tracking cash flows are two simple ways to keep a stronger handle on a firm's market risk.
On a daily basis, a trader's position sheets should be cross-referenced with the day's trading records, consultants say. Both the supervisor and the trader need to sign off on those positions, and discuss the strategies and possible outcomes related to the positions, Mr. Petrash said.
Moreover, there should be a daily trading exceptions report, which would not necessarily limit a trader's ability to trade, but would flag trades of an unusual size or nature, he said. There also should be regular discussions between a trader and supervisor of how particular trades can be unwound if they prove unprofitable, and what will be the costs of unwinding them, Mr. Petrash said.
Tom Ho, president of Global Advanced Technology Corp., a New York-based fixed-income and risk management consultant, said firms now generally rely too much on risk control systems that look backward, and act as more of a report card. Instead, the industry should move to surveillance types of systems that are proactive in seeking out potential deviations from a firm's desired risk, he said.
Mr. Petrash noted a risk management system doesn't act only as a control, but also as a means to profit. They can lead to enhanced opportunities in the marketplace.
While industry professionals were close to undivided on their call for strong controls, the cost of implementing controls is less clear.
The cost of an adequate risk control trading system can run as high as the tens of millions to hundreds of millions of dollars, Mr. Petrash said. It depends on what it is worth for an investment firm's employees to sleep well at night, he said.
Robert D. Arnott, chief investment officer for money manager First Quadrant Corp., Pasadena, Calif., said trading systems are widely available, and not expensive. At the most basic level, "Custodial banks can track aggregate positions," he said.
Greg Pond, president of ADS Associates, Calabasas, Calif., a trading systems firm, said costs vary widely depending on the needs of the institution. His firm has installed its systems and trading software at prices from roughly $350,000 to $3 million.