When the going is good it’s easy to forgo necessary investments in information technology and non-profit centers like controls. Investors put further pressure on bank managements to reduce their non-compensation expenses so that net earnings maintain their upward trend, but there’s little doubt that overall the financial sector’s risk systems and oversight capabilities haven’t kept pace with growth in assets.
Writing down assets due to market deterioration is one thing, but taking a hit as a result of trader errors or fraud reflects an aggressive culture that’s worrying to investors.
Since the start of the year we have seen fraud at SocGen, writedowns at AIG and now markdowns at Credit Suisse: in all three cases investors are left wondering whether these institutions have the right oversight mechanism to correctly handle the volumes of structured and quantitative finance products that come their way.
Credit Suisse impressed the market last week with its disclosures, raising the bar for the entire industry by revealing gross positions in most of its holdings. But now it says it has identified mismarkings and pricing errors by a small number of traders, errors caught by its internal controls team in the last week.
This wasn’t an act of a single trader, but a group. It may reduce the risk of fraud but highlights a potential communication gap between those in charge of internal control teams at group level and individual teams. Combine that with some negative market moves and it has led to $2.85 billion of markdowns in some asset backed positions in its structured credit trading business.
What’s worrying is that an internal probe is still a work in progress and the bank may even have to restate its 2007 earnings.
Banks are notorious for not making interperiod announcements unless it discovers a bad fraud leading to huge losses. Credit Suisse could have kept quiet about it as well, but one of its bond issues is closing today, making this disclosure mandatory.
But when banks are only readying numbers for periodic disclosures, they can resort to various methods of creative accounting to limit the damage to the bottom-line. Moving assets between Level 2 and Level 3, deliberately keeping writedowns in some assets low. Or in some cases not disclosing any exposure at all.
Doubts over Credit Suisse’s controls come at a time when it is trying to regain investor confidence after years of underperformance among peers. It has succeeded to a large extent, avoiding the huge subprime-related writedowns one has seen with UBS.
Tuesday’s markdowns don’t significantly change this theme but it will put pressure on the bank to curb its risk appetite for the time being. Its average daily Value-at-Risk in the fourth quarter of 2007 was 176 million Swiss francs, compared to 95 million Swiss francs in the previous quarter and 70 million Swiss francs in the previous year.
What’s difficult to assess is how much has Credit Suisse has invested in back office and controls infrastructure and non-financial staff that help keep the bank a safe place.
Some of these functions are outsourced and won’t show up directly in the filings. But “other operating” expenses is a good indicator. For Credit Suisse this item rose from 9.23 billion Swiss francs in 2005 to 9.5 billion Swiss francs in 2007, a 3% increase. Goldman Sachs’ total non-compensation expenses rose 57% to $8.19 billion with expenditure in communications and technology alone rising to $665 million from $490 million in 2005.
Credit Suisse’ internal review isn’t yet over. The much-waited rerating of the stock vis-a-vis its peers will have to wait for now.
The Swiss firm blamed pricing errors for its actions, which would cut $1bn from expected first-quarter profit.
It also blamed "adverse market conditions" for the write-down.
The news comes as confidence in the global banking sector is at its lowest ebb in years, hurt further by a trading scandal at France's Societe Generale.
The disclosure came after an internal review, which the bank said was continuing.
In a conference call, the firm's chief executive, Brady Dougan, blamed most of the losses on negative sentiment in the market.
But he also pointed to "late marking" - the failure to update pricing within the required time limit to reflect market movement.
He declined to comment on whether the traders involved had kept their positions inflated to bump up their bonuses, but would not rule out fraud.
'Tip of the iceberg'?
| || This is a disaster |
Peter Thorne, Helvea
Tuesday's revelations by Credit Suisse stunned many analysts because they came a week after the Zurich-based firm posted its results for the last three months for 2007.
At the time, it reported minimal damage from the US sub-prime crisis, with losses of 2bn Swiss francs ($1.8bn; £938m) last year, less than it had originally expected.
"This is a disaster. This could be the tip of the iceberg," said Helvea analyst Peter Thorne.
Mr Dougan said there was "no indication" that Credit Suisse would have to restate 2007 earnings, which it reported last week, but he added, "That is under review."
He also said the bank was profitable for the quarter to date and that it was "extremely well capitalised".
Bear Stearns analyst Christopher Wheeler was sceptical.
He said: "Given the tentative nature of the announcement, it is not certain that we have heard the last of this issue."
"Those who thought that certain banks such as Credit Suisse were 'out of the woods' should exercise caution," he added.
The revelation cast a cloud over the banking sector in Europe, which has fallen out of favour with investors since last summer, when it began to emerge how much risk banks had taken on in the boom time.
Huge bets on the growth of the US housing market have turned spectacularly sour as the US weathers its worst slump for two decades.
Swiss banking giant UBS has been one of the worst European banks affected. Taking an $18bn write-down on investment losses, it recently posted the first annual loss since it was created by a merger a decade ago.
Wall Street giants, including Merrill Lynch, Citigroup and Morgan Stanley, have all experienced problems, and were forced to turn to cash-rich Asian and Gulf investors for help to rebuild their balance sheets.
Questions have also been raised about the risk controls at banks after illicit trades at Societe Generale cost it 4.9bn euros.
These concerns will come to the fore once more after Credit Suisse's announcement, analysts say.