Implementation of Risk Management

Given the advancement of knowledge and technology, we should find it easy to claim that risk management of financial markets is more sophisticated than those in two decades ago. However, how come financial scandals could happen in financial institutions with a strong risk management team? One of the reasons is weak implementation of risk management policies and procedures.

This week SFC issued a circular to mention its recent inspection findings that some securities dealers may be failing to manage their risks prudently, such as client overtrading, margain shortfalls, a major client default, liquidity squeeze, etc.

Some unacceptable risk management practices are highlighted by SFC:

• Risk management policies and procedures, even exist, are not strictly enforced, where management overrides them actively or tolerates non-observance proper jurisdiction.
• Failure to apply a sufficient hair to securities collateral.
• Excessive exposures to individual clients and particular securities.
• Failure to prevent clients from exceeding pre-set limits and lax margin call procedures.
• Allowing cash clients long credit periods to settle their trades and allowing margin clients to trade when their accounts are under-secured.
• Taking on settlement obligations that significantly exceed the aggregate of the broker's available cash and banking facilities.

Actually all of the above problems happen 10 years ago during the stock market crisis, where many securities brokers had collapsed. Up to today many people have not yet learnt the lessons.

Wicked Brokers

FINRA has recently charged registered representative John Edward Mullins with misappropriating almost US$400,000 from a 97-year-old nursing home resident who was a Mullins' client for more than 20 years, as well as from her charitable foundation. The customer has recently passed away. Broker Kathleen Maria Mullins, John Mullins' wife, was also charged with wrongdoing.

In addition, FINRA charged John Mullins with attempting to misappropriate funds from his employer relating to improper expense submissions, accepting an unauthorized US$100,000 loan from the client, and making misstatements on his firm's annual compliance questionnaires and Form U4 (Uniform Application for Security Industry Registration or Transfer) in an apparent effort to conceal his officer and trustee status with the charitable foundation. Kathleen Mullins was charged with accepting a loan from the customer and making misstatements on her Form U4 and annual compliance questionnaires. In addition, both were charged with failure to adhere to high standards of commercial honor and just and equitable principles of trade.

Shortly after the customer's husband died in Dec 1999, the customer established a charitable foundation to receive and administer funds for the benefit of charities devoted to the promotion of musical arts in Philadelphia and the New Jersey Shore. From its creation, the Mullins both served as trustees and officers of the foundation. When the customer initially entered a nursing home in 2000, the Mullins were provided power of attorney over the customer's assets, including the ability to conduct banking transactions and withdraw funds. From about Apr 2006 through Jul 2006 - when the customer became ill and was hospitalized - Mr. Mullins misappropriated almost US$400,000 from his longstanding client. With the elderly customer's health deteriorating, he took advantage of her condition by using her checking account and debit cards to pay for his and his wife's personal expenses, including paying down US$375,000 in their joint mortgage credit-line account.

Beyond paying off the mortgage credit-line, Mr. Mullins began to use the customer's checks and debit cards largely to make purchases for himself and his wife. These purchases and debits included: US$14,120 in ATM cash withdrawals, US$11,264 for meals at restaurants, delicatessens and purchases at confectionary shops, US$4,653 for groceries and US$1,046 for gasoline. John Mullins signed either the customer's name, or his own name, to debit card receipts.

In addition to the customer's personal assets, funds were also misappropriated from the charitable foundation account, set up by the customer at the brokerage firm that employed the Mullins'. For example, John Mullins used the customer's foundation account debit card to purchase approximately US$16,500 in gift certificates. He then redeemed US$5,500 in gift certificates to pay down a retail store account bill, and redeemed US$4,000 in Four Seasons Hotel gift certificates during a vacation to London that he took with his wife.

Comment: 人渣！

P.S. Unfortunately, there are so many wicked brokers / agents like the abovementioned couples in Hong Kong.

Sub-prime Crisis

Subprime crisis continues to be a major concern by regulatory bodies. At early Feb 2008, the IOSCO Technical Committee reviewed the progress on the sub-prime crisis, focusing on four key issues:

• enhanced transparency by issuers of structured products and appropriate due diligence frominvestors;
• risk management process for intermediaries;
• valuation and accounting issues; and
• the roles and duties of credit rating agencies.

The Technical Committee discussed various possible advancements in the model IOSCO Code of Conduct Fundamentals for Credit Rating Agencies, including:

• disclosure of the assumptions underlying the individual ratings for structured finance transactions;
• prohibition of advice on the design of structured products which an agency also rates; and
• reasonable steps being taken to use information of sufficient quality to support a credible rating.

The Technical Committee also outlines several key steps that can be taken by market participants to help restore confidence in the operation of the market:

• Financial institutions are encouraged to enhance the information available to the primary market for structured finance instruments;
• Market participants should cooperate to identify information that would be relevant and useful in achieving an appropriate level of transparency in the secondary market;
• Financial institutions should make accurate and complete disclosure of the size and the level oftheir exposures related to structured finance to the market;
• Institutional investors and asset managers are encouraged to develop and undertake strict due diligence processes in their assessment prior to any investment into complex, structured products.

Every time when there is a wide-spread financial crisis, the fundamental problem identified by the regulators is associated with transparency and disclosure. This is always a hindsight. If regulators are unable to fully understand the systemic risks created by a new financial instrument in advance, new types of crisis will burst again and again in the future.

How Do You "Know" a Person?

Persons under SFC's investigation are often found to have provided false or misleading information to SFC, then they would be subject to a heavy penalty. However, last week Eastern Magistracy acquitted Mr Hui Ngai Hon Edward, Mr Ho Tung Wan (formerly known as Ho Wai Chun) and Mr Lam Yiu Lun of three charges of misleading the SFC. They were alleged to have misled the SFC on a critical issue as to whether they knew each other during an SFC investigation into a market manipulation case.

In interviews with SFC, Hui and Lam said they did not recognise Ho's name, and Ho said he did not recognise Lam's name. On the other hand, SFC obtained an evidence from third parties including a statement from a travel agent, who said that Hui, Ho and Lam took holidays together. However, the magistrate ruled that there was insufficient evidence to prove that they had misled the SFC. This was based on the view that SFC did not prove that the defendants knew one another's full Chinese names when they were shown to them by SFC in the interview.

The magistrate's ruling is not unreasonable. You may "know" somebody simply by being able to recognize his appearance. You may not know his full Chinese names if usually you call only his English name. Perhaps in future SFC has to provide a photo to perform this "knowing" test!