The Need for Continuous Monitoring and Assurance of Financial Transactions.

1. The Need for Continuous Monitoring and Assurance of Financial Transactions. Miklos A. Vasarhelyi – KPMG Professor of AIS, Rutgers Business School, Technical Lead, AT&T Laboratories Michael Alles, Associate Professor, Rutgers Business School Alexander Kogan, Professor, Rutgers Business School

2. Outline Why don’t we learn? The anatomy of a crisis Monitoring financial institutions A proposed solution methodology Issues for research

3. 1. Why don’t we learn?

4. Why don’t we learn? In 1997/1998 LTCM failed precipitously forcing the Fed intervention to coordinate 16 banks to contribute close to 4 bi dollars to shore up an institution largely deregulated that was operating with leverages around 30 times capital, ignoring even their swap and derivative positions The total effect on the economy, justifying the Fed’s action was estimated to be about 1 trillion dollars Among the major players for countertrades and financing for LTCM were Bear Sterns, Chase, and Merryl Lynch The epilogue was that these firms escaped largelly unscatted and recovered their investment and loans with positive returns in about 18 months after Mr. Greenspan’s interest lowering

5. Why don’t we learn? (2) Greatly contributing to the crisis, net of the different international currency crises, were the total lack of transparency of LTCM positions the ignorance by counterparties of LTCM of their intricate web of relationships and exposures the nearly totally unregulated nature of hedge funds the immense greed of both LTCM partners and their counterparties the lack of disclosures on derivatives by all parties

6. Why don’t we learn? (3) Since those days (10th Year anniversary celebration of LTCM) The FASB issued derivative disclosure rules Many other types of financial instruments continue to be non-reported under the guise of competitive impairment As private equity and hedge funds remained largely unregulated and Sarbanes increased the onus of regulation a large amount of funds was routed to these entities The financial institutions refined the use of SPElike entities for their funds The amounts at serious risk are now in the hundreds of billions not in the pittance amount that partners were forced to contribute at LTCM

7. Background considerations The ill defined nature of the boundaries of business entities making them outside the scope of existing audit practice. The inability to fully assess the value at risk from financial instrument and contracts. The interlocked nature of financial entities and instruments that are being measured, Even seemingly sophisticated real-time controls have weaknesses stemming from their own lack of security, monitoring and alarm handling features.

8. 2. The anatomy of a crisis

9. Six waves 8 6 5 2 4 1 3 Sub prime Derivative Instruments Hedges & Private Equity Swaps US Recession International Recession 7

10. Some other key effects – un-antecipated A major crisis of confidence melting the intermediate markets Substantive de-leveraging aggravating the lack of credit The disappearance of the large US investment houses in the form we know them

11. Effects on the six waves Sub prime Derivative Instruments Increased liquidity from the sub prime lead to derivatives Credit-default swaps are derivatives, meaning they're financial contracts that don't contain any actual assets. Their value is based on the worth of underlying loans and bonds. Derivative Instruments Hedges & Private Equity ``I think there's a major risk of counterparty default from hedge funds,'' Cicione says. ``It's inconceivable that the Fed or any central bank will bail out the hedge funds. If you have a systemic crisis in the hedge fund industry, then of course their banks will take the hit.'' Hedges & Private Equity Swaps Investors can't tell whether the people selling the swaps - - known as counterparties -- have the money to honor their promises Combination of absolute fear and investors really not knowing

12. Effects on the six waves (2) Swaps US Recession With the deepening of operational financial problems, bonds default, and swap obligations become due 5) US Recession International Recession The interconnectivity of markets, a basis for their increased efficiency, becomes a compounding / accelerating factor 6) Derivative Instruments Swaps There is no real regulation in swaps and their trading creating a shadow market that is larger than regulated markets

13. Effects on the six waves (3) Swaps Sub prime (encompassing intermediate waves) Billionaire investor George Soros says a chain reaction of failures in the swaps market could trigger the next global financial crisis. The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb. On May 8, American International Group Inc. wrote down $9.1 billion on the value of its CDS holdings. The world's largest insurer by assets sold credit protection on CDOs that declined in value. In 2007, New York-based AIG reported $11.5 billion in writedowns on CDO credit default swaps. US Recession Sub prime (encompassing intermediate waves)

14. How can CA and/or CM help? A forward looking environment Monitoring companies close to real time will allow for identifying and preventing potential issues (i.e. defaults in sub prime) Analyze schema of debt and understand the impact with income and mortgage terms to determine predictors Use of analytic continuity equations to create linkage Publish process relationships and forward looking metrics Transparent monitoring can create additional instability in the markets Alike fair value regulations can be blamed for increased instabilities But will reduce counterparty opacity Necessary for long term regulation and stability

15. Perverse incentives Loan originators and loan carriers Praying on uneducated consumers Too complex titles Rating agencies Being paid by the rated entities Accounting rules Allowing again “off balance sheet entities” Fair value valuations precipitating unintended consequences … a cooling period with double reporting would help Clueless in non regulated markets Clueless in dealing with regulated interfacing with unregulated parties Clueless in general ☺ ☺ ☺ ☺

16. Markets Disappearing The credit crisis has choked off many of the markets that banks in recent years relied on to take assets off their balance sheets. Issuance of mortgage-backed securities has dropped sharply, while demand for more complex instruments such as collateralised debt obligations – packages of loans that have been sliced to create new securities – has dried up completely. Many bankers think it will be months, if not years, before they can start issuing these securities again. If and when they do, investors are bound to demand higher returns than before and are likely to require banks to demonstrate confidence in the securities by keeping a greater proportion themselves. In short, this means that banks will be forced to fund more of their future loans from their own balance sheet resources.

17. 3. Monitoring financial institutions

18. Are the raters reliable monitors? Standard & Poor’s to revamp its governance procedures, analytics and ratings transparency mark the latest in a series of mea culpas from the leading credit rating agencies as they attempt to restore their credibility with investors. Moody’s, Fitch and S&P have in recent months come under intense fire from investors and regulators in the US and Europe after complex structured finance instruments they rated have suffered losses far in excess of the rating agencies’ initial expectations.

19. Is the government a reliable monitor? The government has stayed largely in the sidelines watching the financial bubble grow The regulator umbrella is cumbersome, prone to political intervention, and lacks effective weapons to deal with the powerful banking establishment Since the deconstruction of the Glass Seagall act banks have become investment banks and vice-versa. Hedge funds and private equity have taken secondary and tertiary roles in this process.

20. Are auditors reliable monitors? External audit methodology is anachronistic The point-in-time audit is not designed to Monitor fast moving financial operations Detect going concern weaknesses in short periods of times Measure integrated risk faced by financial institutions Deal with the fuzzy boundary issues of interlinked financial agents Internal audit groups Are better positioned to deal with these issues Do not have the monitoring and control charter Need to develop a comfort zone for monitoring and assurance functions to be negotiated among the Basel II, compliance, fraud, Sarbanes, and operating groups

21. 4. A proposed solution methodology

22. Database to database confirmations Counterparty 1 4. high level set of risk KPI and monitoring alarming 3. library of derivative valuation programs 5. Analytic continuity equations 2. A reporting level control panel FI enters in thousands of Derivative transactions 6. alarming/management methodology Counterparty n • Many transactions are multiparty • Similar instruments are actual different • There are tight and loose hedges • Catastrophic changes in markets are of dubious headgeability

23. A proposed approach A library of derivative valuation programs drawn from various sources, both external and internally developed. A template for a linkage methodology where related derivative instruments part of a coordinated hedge will be linked A high level set of risk KPI and monitoring alarming features A reporting level control panel in addition to other alternate views. An initial taxonomy of instruments, valuation measurements, and controls A set of analytic continuity equations linking: varied outside market conditions; clearance agents; derivative instrument and security positions, and different views of risk exposures

24. A proposed approach (2) A representation of clearance agents, clients, other paper issuers, SPEs, and other relevant entities A representation/experimentation in the concept of confirmatory extranets in the validation of the existence of tertiary transactions and of “ownership” of particular securities An alarming/management methodology to mitigate the danger of rogue trading and unbalanced derivative positions Simulation of several alternate conditions/contingencies based on published reports of recent frauds at Societe Generale, Citigroup, Barings and so on to test the validity of the proposed approach as a preventive and detective control.

25. 5. Issues for research

26. Outcomes The result is that a banking industry has turned out to be supporting a much larger asset base To make matters worse, the previously hidden assets are often those whose value is the most suspect. The financial system has become leveraged to a greater extent than one could have guessed The government intervention in Bear creates an immense moral hazard problem / Lehman’s failure a serious mistake The injection of resources in the system and drastic reduction of the interest rate create the danger of long term inflation / short term deflation and the roots for the next financial bubble We may be nearing limits on the ability of the US government to borrow A New Deal II program unavoidable

27. Research questions Can a technologically based solution and new audit methodologies be derived to deal with or mitigate these problems? How good are the current risk management platforms at the financial institutions? Can a platform just involving one institution without spanning its counterparties be relied upon? How to reduce the moral hazard of greedy bankers and traders where society will finish up paying? While regulators diddle with the desirability of XBRL the question that looms is if version 2.1 is adequate to represent fast moving instruments or new XML extension languages have to be created to deal with the “live financial report”