Stop Burning Money: Learning From JPMC’s Financial Mistakes

Posted on May 14, 2012 by

If you’re a long time reader of this blog, you know that for some time we’ve been discussing project management in the largest possible sense. For many, project management is all about managing the schedule and budget of a project. My view is that the project budget and schedule are merely outputs of a much more involved process. The basic tools of project management are very similar to the tools of many other offices: procurement, audit, business improvement, etc. But, in a well-managed firm the threads of all of these different departments come together in the PMO Project Portfolio. Firms, especially financial firms, are now so large and interconnected that individuals and departments can control billions of dollars of assets and leave almost no “footprint” on the firm (i.e. process documentation, business objectives, scope of responsibilities, stakeholder buy-in, etc.). Last week, we heard that JPMC (the world’s largest bank) ran a “loss prevention department” that lost $2 billion. How did that happen? How do you prevent it in the future?

The short version of the story goes like this. JPMC manages many billions in their security portfolios. To limit the risk in these groups, JPMC created a hedging group to limit the possibility of losses on that portfolio. How does a hedging strategy work? It can get very complicated, but essentially it is about putting together a basket of assets that moves in the opposite direction of the assets you are trying to protect. These assets are almost always leveraged (borrowed money used to “amplify” profits). That means that if your primary asses go down, the hedge fund goes up…. Which provides the profits to protect your primary assets.  In a recent blog we went over the details of hedging and how it has led several of the last market collapses. That’s not to say that any one hedge fund is necessarily bad, but all hedges have an Achilles heel. They work perfectly, except for the day when they go through the floor. Each Achilles heel is different and depends on the math behind the fund: it could be a sudden rise or dip in the economy, or a sudden drop in the Asian real estate markets, or loss of confidence in a type of financial instrument. All of these changes have happened, and as a result we had market and economic collapses in the 80s and 90s.

When these strange activities really get going, the next step is that the biggest of these funds keeps increasing its “bet” until it is astronomical in size. If that’s a bad bet, then the firm and even the entire economy can take a fatal hit. We have heard that the damage was $2 billion (this may rise), but the bet was much larger… $100 billion. The bet was only slightly wrong, and lost 2% (i.e. $2 billion). It could easily have been 5 or 10 billion, or more. However, this time, something very different happened. The CEO of JPMC, Jamie Diamond, did something we haven’t seen in a long time. Before he was required to, he publicly reported this problem… BEFORE HE WAS LEGALLY REQUIRE TO REPORT IT! This is one of the reasons that Mr. Dimon has been called America’s best CEO of banking. It took real guts to do this, rather than trying to “fix” the problem with even riskier trades to cover the problem… which has been a recurring problem with other banks. However, if Jamie Dimon is the best CEO of a bank, and JPMC I the best bank in the world, then we have to assume that the JPMC problem is neither unique nor the worst example of what we can expect in the future.

According to Dimon, “There were many errors, sloppiness and bad judgment. These were egregious mistakes, they were self-inflicted.” On “Meet The Press” (5/13/12), Dimon added that JPMC had many billions invested in security portfolios and needed to build a group to hedge the risk for their portfolios; unfortunately, the strategy for that group was, “badly vetted, badly monitored.”

Dallas Federal Reserve Bank President Richard Fisher, said the biggest banks do not have adequate risk management. ”What concerns me is risk management, size, scope… At what point do you get to the point that you don’t know what’s going on underneath you? That’s the point where you’ve got too big.” For once, we see commonality between the banks and the regulators. Even when every department produces management reports, these big firms do not have transparency in their operations.

The PMO’s project portfolio is more than a list of projects. It is a crystal ball into the thinking of individual departments. If the PMO is truly global, there should be a section in the folder for each department. When there is a gap in the portfolio, a department with no projects, that’s a sign that this department either is not very connected to the rest of the firm, does not see itself as having any need for improvement, or does not wish to expose it’s operation to the firm.

  • Not connected: There are a lot of reasons for a department to not take the time to work with the PMO. Big deals, high pressure meetings, highly paid staff with better things to do. But these are the same reasons why the department may not be well connected with regulatory and control department. Today, there is a lot of talk about whether bank regulation works, if JPMC had this problem. However, much regulation occurs after the fact. Because of reporting requirements, Dimon found out about this loss. But if there was more exposure of the working of the hedge process, other stakeholders might have raised questions or escalated the issues.  For example, did the fund change its philosophy and did this change lead to the loss? If so, what about changes to their trading systems, training, etc. There are rumors that this loss prevention department was changing its shift to profit making. Did that happen without a project?
  • No problems: When a department does not believe that it has any problems to fix, it invariably has a lot of problem. Perhaps more importantly, it has been able to fool itself into not seeing its flaws. Or believing that only it’s managers are capable of identifying or fixing their problems. This is a high risk thought process. But it’s not uncommon. If we look at a lower-risk industry, we can learn something important. Take supermarkets. Every supermarket is a bit different. The demographics of the neighborhood change, and the physical space varies between supermarkets. Every supermarket manager needs to make compromises to maximize profitability. Managers compete fiercely against each other for the honor of top store manager. While the financial reward will not be as great as a top fund manager, it matters a lot for a supermarket manager. Yet, the head office frequently rotates managers because of “store blindness.” After being in one location for a while, managers have lived with their weaknesses for so long, that they become blind to them. This condition is progressive, creating an ever expanding blind spot where effective management cannot occur. It is no different in banking.
  • Resists exposure: We all know that some manager are more helpful and others are less helpful in developing projects. But managers that are completely absent should set off a red flag. Especially if they are responsible for high-value  assets. High-value and high-risk  operations should be the most connected operations within the firm. They need to have regular contact with stakeholders in other departments, including regulators. The project portfolio should provide insight into the intentions of the that department. Active resistance to exposure can be a culmination of the other influences (everything is OK, I have no reasons to be connected, I don’t need help from other department, etc.).  However, it could also be that the operations of this department are too proprietary, too confidential to be exposed to the entire PMO. If this is the case, I would argue for a sub-department… the Confidential Projects PMO.  This would be a smaller group that only works on projects with high levels of confidentiality.  Big financial firms must flow information from business units to many other groups (IT, compliance, legal, HR, etc.), so there are few legitimate reasons for not injecting PMO disciplines into the top levels of business thinking.

Irony truly rules the world. JPMC created a group to prevent losses in portfolio trading, which pursued a high level risk strategy that has cost the firm $2 billion… so far. Yet this highly leveraged strategy could have cost JPMC much more. You can be sure that JPMC is combing through the firm to find out if other departments have gotten out of control. Expect high-level resignations and executives who suddenly have an urge to spend more time with their families. Will other firms take this as a cue to ensure that departments with the highest risks and most valuable assets are fully connected to the rest of the firm, including the PMO? Will financial firms take advantage of the position of the PMO, and the analytic skills of their project managers, to analyze the project portfolio to find signs of risk behavior and operational blindness? Probably… they will. But not until we have a much bigger and more visible blow-up. And when that blows-up happens, expect a blow by blow examination on this blog site… and that’s my Niccolls worth for today!

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The Game Of Money Laundering, Part 2

Posted on May 6, 2012 by

In our last blog we discussed the origins of money laundering and how it evolved over the years. We know that when criminal organizations create big piles of money, they can’t do very much with that money until it moves from the shadow economy into the legitimate economy. The use of computers and global banking creates more opportunities for criminals to sneak money into banks and financial institutions so that they can launder the money and move it back into the economy. The new economy makes the process more complex and more difficult to follow. Still, while this may be a game of “speed laundering” it’s still the same old game. At least it was until recently. There’s a lot happening on-line that could create new opportunities for money laundering. Today, we’re going to look at one particular scenario that may give us a sneak peek into the future. Let’s dive right in!

The latest money-laundering  schemes are driven by technology. Deals move faster and in smaller increments, making it harder for the good guys to find and catch the bad guys.  But when technology combines with innovations in commerce, we get entirely new types of risk. Consider eBay. This firm started out with an idea for a simple auction system. You have a painting that you never really liked, so you sell it on eBay and  make a few hundred dollars. Why is that a problem? Well, auctioning isn’t normally a part of the world of finance, so it falls outside of most financial regulations. Add to that the incredible growth of eBay, and we have a unique situation. Old school auction houses, such as Christies and Sotheby’s have been around for hundreds of years, hosting auctions of the world’s finest art and artifacts. At the end of 2011, Sotheby’s had an auction of contemporary art with sales of $200 million in a single night. Yet, the best year for Sotheby’s or its close rival Christies, has been about $6 billion. This year eBay will pass $150 billion in sales of decidedly  more downscale merchandise. That’s more than the economies of 100 countries, and rivals the GDP of Bulgaria. The “micro” auctions that typify eBay’s auction model is the perfect vehicle to launder a lot of illicit funds. Why does eBay have so much potential as a money-laundering  machine? Four reasons:

  1. Biggest Player: First, eBay is the biggest on-line auction service. There are other services out there that could do the same scams, and they might be doing that even as we speak. However, the sheer size of eBay makes it the most likely place to look for big scams.
  2. Illegal Activities:  Ebay has many programs and documents that talk about crime prevention. However, eBay has hosted criminal activity with alarming regularity. The most basic crime on eBay is the selling of items that the seller does not possess, and the seller simply walking away with the cash. A step up from that is identity theft, and unpaid purchases from these accounts. Stolen goods are regularly sold on eBay, much as criminals used to sell stolen goods to a pawn shop. Of course, eBay has gained quite a bit of notoriety as the world’s largest market for counterfeit goods, often in conjunction with international criminal organizations.
  3. Little Regulation: How can eBay be involved in so many criminal activities and still be in business? It’s because the auction industry is very lightly regulated, and in many locations not regulated at all. There are no international regulations for auctions. Because the auction house does not sell anything… they merely provide a marketplace for sales to take place… most legal systems do not hold the auction house liable for the details of transactions. Tiffany’s, the well-known jeweler, has been suing eBay for nearly a decade because of the volume of counterfeit Tiffany’s goods sold on eBay. The courts have backed eBay, stating that an auction house must  do more than host an auction to be liable; it must attempt to influence the sale (such as falsely documenting an item’s value), or prevent the buyer from discovering a fraud. Even being aware that an item is most likely counterfeit is not enough to make the auction house liable.
  4. Paypal Connection: So far we have a huge auction house with a lot of questionable transactions, but nothing that looks like a threat to international banking. However, we haven’t asked how are payments made on eBay? A few years ago eBay asked this question, and wasn’t happy with the answers. Auctions were constrained by unreliable or slow payment systems. In 2002 eBay bought the electronic payment firm, PayPal. PayPal connects your bank account or credit card to eBay’s auctions and facilitates a rapid payment. According to Wikipedia, Paypal has 232 million accounts, with customers in 190 countries, using 32 currencies. With PayPal as part of the system, the lightly regulated eBay has the global reach to allow criminal activities to develop extremely complex layering schemes… that eBay would not be responsible for. Yet, any such scheme would pass through many banks. Today’s Anti-Money Laundering legislation might hold these banks accountable for involvement in any criminal activity. At a minimum, it would be a black eye to see your bank’s name in the Wall Street Journal because of activity on eBay.

Few banks are aware of the number of illegal eBay transactions or have processes that can prevent involvement in an eBay fraud. Individuals who have been scammed on eBay may contract their banks to stop a payment, but many of these crimes are not reported. True money-laundering  schemes may just go unnoticed. But what if the situation is much worse than what I have described? What if eBay worked with an organization that auctioned items that didn’t exist, always used false names and  wore disguises to hide their identify? We don’t have to assume. This already exists throughout the world of on-line gaming. Not gambling, gaming. As in elves and dragons or light saber wielding Star Wars fanatics. What’s going on here?

The granddaddy of on-line gaming or MMORP (massively multiple on-line role playing) is World of Warcraft (WOWC). This one game generates about a billion dollars a year in subscriptions, and an unknown amount of additional money in “commerce,” from its 12 million users. If you’re the kind of person who spends a lot of time on WOWC, you will eventually need to kill an enchanted dragon or go on a quest for some rare object. To get that object you could spend months performing time consuming tasks, or you could simply buy that object from someone. Not too long ago you would pay fantasy world currency for fantasy world  products; today, you pull out your credit card and pay real money. Virtually all of these transaction pass through PayPal.

These fantasy auctions are largely innocent, criminal history tells us that every big criminal scheme was based on a smaller, earlier version. In our last blog we discussed Al Capone’s use of prohibition to develop an immense criminal empire. We know that eBay has a history of supporting petty theft and unethical behavior, but current law holds the seller… not the auction house… responsible for crimes. Based on other crimes, it’s not hard to imagine that small sums of illicit money are moving through fantasy auctions. Role playing sites are growing very quickly, and the opportunity to hide and launder money will grow along with these sites. The combination of MMORP sites, little regulation of eBay and the money moving capacity of PayPal we have a platform to accomplish very sophisticated money laundering. Because banks can be unknowingly enmeshed in these transactions, financial institutions need to understand how eBay is evolving and if it is creating a backdoor for criminals to move money through international banks.

In the last century, police departments kept an eye on pawn shops to find clues about crimes and even get a jump on new potential criminal activities. Ebay has become the world’s pawn shop, and will require similar policing. However, eBay, unlike pawnshops of old, has enmeshed banks and financial institutions through PayPal’s connection to bank accounts and credit cards. Over time more advanced payment systems will enter the market,  but may share eBay’s exemption from financial regulation. We can expect criminals to exploit any new opportunity to launder money. Will banks remain one step ahead of the criminals? They might, if they examine and understand new and emerging threats to the banking system. At least, that’s my Niccolls worth for today!

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A Game Of Money Laundering, Part 1

Posted on May 1, 2012 by

Wherever  illegal money exists, there is a need to “launder” that money so that it can be used in the legitimate economy. In the earlier part of the 20th century, most “money laundering” schemes came from criminal activities. American and foreign Mobs  flourished in the first half of the 20th century, initially as relatively unorganized groups that profited from extortion, robbery, gambling and other illegal activities. Individual criminals, or even a small gang, could live a comfortable life outside of the legitimate  economy. That life would need to be conducted entirely in cash, but that wasn’t a problem when cash was the predominant economic medium. Just as corporations grew in size, criminal organizations also merged and grew, and began to generate much more money than in the past. At the same time the economy moved to credit, credit cards and banking institutions. The new crime mobs had far more money than ever before, but had fewer ways to move that money back into the legitimate economy to buy a car, house or a business. The Mob was “stuck” with massive amounts of cash, and few ways of using that cash without exposing themselves to criminal prosecution. Today, we’re going to look at the origins of money laundering, how the process works and then we’re going to identify future money laundering threats.

The interest in large scale money laundering probably begins with the infamous Chicago Crime boss, Al Capone. Capone had worked his way up the mob ranks and had big plans for the Chicago mob. As Capone began his reign over Chicago, the federal government passed the Volstead Act, making the sale of alcohol illegal. This provided Capone’s organization with a huge market for illicit alcohol, and the ability to charge virtually any price for an already highly profitable commodity. In today’s money, Capone made billions of dollars annually. As revenues and violence escalated, many legal organizations tried to stop Capone and failed. Capone was a clever opponent with vast resources, who had managed to corrupt local police, politicians, judges, newspapers, and entire communities. Even the fledgling FBI failed to stop Capone without much success. Then, an FBI agent named Elliot Ness began investigating revenues from Capone owned businesses. This worked was then refined by Frank Wilson, who matched revenues to Capone’s income taxes, and eventually won a conviction for the notorious gangster.

This experience taught the government that It’s easier for criminals to cover up a crime than to cover up the income from crimes, especially in large criminal organizations. They also learned that by effectively limiting the movement of  illegal profits into the legitimate economy, you can limit the size and power of crime families. However, criminals also learned from the Capone conviction. They learned that big piles of money can be a double-edged sword. If you spend a lot of money, you need to explain where it came from. Even if the government can’t prove it came from a criminal activity, you still need to prove it came from… somewhere! If you can’t, you will leave a trail on your tax forms that will eventually end in a jail sentence. Alternatively, you can just sit on your pile of cash, but if you can’t spend the money why bother to even break the law to make the money? Of course, if you had a magic machine that could cleanse money of illegal activities, getting the money into the economy would be a cinch.

Criminals have been looking for that magic machine for decades. The best example in the 20th Century was the cigarette vending machine. You could find one in any bar, club  or dinner, anywhere in America. It starts with PLACEMENT, when the Mob creates a company to install the machines and will mark up the sales on each machine to show revenue. The revenue claimed through thousands of individual cigarette machines becomes very difficult for the police or the IRS to trace. Blending legal with illegal money on each cigarette machine creates enough confusion to hide illegal money. This LAYERING of money can be further complicated by introducing illicit cigarettes (stolen or with forged tax stamps), altering purchase records to make sales appear higher, and movement of money though other fake corporations. Once the money has been passed through a bank, perhaps changing hands and names in the process, it comes out the other end of the banking system (INTEGRATION) as clean, legitimate money.

In a simpler time, this process work very well. But times changed. Cigarettes were slowly banned from most public meeting places, but new scams replaced the old. The rise of credit cards, and then on-line business and the connected  global economy, created new opportunities to create illicit profits and to launder the money. Electronic transfer increased the speed and size of money laundering schemes. Today’s globally connected world means that money laundering can begin or end anywhere in the world, as funds move across borders. The high speed processing of computers makes it possible to slice money into smaller increments and spread them across a much larger number of accounts than would be possible working manually. Banks and financial institutions have countered with  tighter controls and computer based monitoring. Modern money laundering looks less like a recognizable series of transactions than a cloud of data patterns pulsing across the globe.

The basics of money laundering hasn’t really changed. It starts with placement of funds, followed by layering of deals and accounts to hide transactions, and ends when the “clean” money is integrated into a well laundered account in the legitimate economy. Computers make the process faster and global market makes it harder to find, but this game of cat and mouse has remained the same for decades. But it’s about to change. E-commerce has added some interesting twists to money laundering, and a big player in e-commerce may be about to start the next big thing in money laundering. And that’s where we will pick up part 2 of this blog, but for now… that’s my Niccolls worth!

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PMO Basics: More About Risk And Financial Crises

Posted on April 30, 2012 by

In our last blog we talked about Basel III and the need for better risk identification and quantification by international financial institutions. Today, we’re going to continue with this theme and look at the cyclical process that the financial markets follow, that leads to periodic financial crises.  Basel III can hopefully reduce the damage and duration of the next collapse, but history tells us that collapses will happen regardless of our efforts to prevent them. This blog will help the PMO and project managers to recognize the elements of each coming financial collapse and plan projects that can support new regulations and mitigate damage. We’re now at the start of a new cycle, so there is much for us to learn. Let’s get started!

Since 1990, the world has seen at least 3 major financial collapses. Each collapse was unique, yet each also had very identifiable and repeatable elements. In retrospect, experts have argued if the collapse was a result of market forces or of illegal activities. Each time a highly reputable and very large financial firm has driven the collapse, although after its reputation is established the product spreads throughout the financial world. Each of these collapses has followed this five-step  process:

  1. Niche product: It starts with some financial expert identifying a niche product. Sometimes it is a product that has been traded for a very long time, but only by specialists it is difficult to understand or has considerable risk. One day the financial expert asks the question, “How can I expand the size and profitability of my market?”
  2. Reduced risk: Either that expert, or an expert in some other field, comes up with a new idea. This idea will neutralize some or all of the risk. At least under certain very specific conditions. It could be that the way of measuring risk has remained unchanged in a long time, but the risk itself changed a long time ago. It might be that inside of a very large market there are “outliers” that don’t really match the profile of the rest of the market. New technology might even allow you to do something that has never been done before.
  3. Improved value: If your solution can reduce risk, and if the world accepts your solution, then your “new and improved” financial instrument is worth more than the previous value of the underlying assets. Without a free market to determine the “real” value, who determines the price of this product? Lacking market pricing valuation is often determined or overly influenced by the manager of the product/fund, rather than by the markets or an impartial outside force. When pricing is set by individuals with a strong interest in the value going up, products tend to be overpriced.
  4. Demand & overuse: If the new product survives for a reasonable amount of time, and outperforms more established products, new investors will want to participate. The original firm may expand a fund and/or create new funds that use this product, or other firms may create similar products and funds. However, niche products are by definition small market products. How do you take a product worth tens or hundreds of millions of dollars, and satisfy a market worth tens of billions of dollars (or even more)? Apparently, you can’t. When demand exceeds the total supply, you’ve got to define something else (hopefully similar) to make more. This introduces new (and often undisclosed) risk.
  5. Contamination: Some event occurs that causes doubt. The original fund starts to fall. But that’s OK, this was just a niche product right? No! Because it was redefined to fit demand, it is now a huge amount of money. Still, if the product was called an “ABC Derivative,” you just need to avoid all “ABC Derivative” funds, or funds that act like it. Wait a second, who has been buying these funds? The unfortunate answer is… other funds! While you would never buy it, a “safe” fund in your pension plan bought it to boost this year’s lackluster performance. Now, investors panic because no one knows exactly which funds have direct or indirect investments in this “contaminated” asset.

That’s a long chain of pretty unlikely events… isn’t it? Unfortunately, history tells us that this chain of events is not just likely, it may well be inevitable. Let’s look at the last few big crises and see how they follow this pattern.

(1990) Junk Bonds – Drexal Burnham Lambert: Bonds are promissory notes to pay back your investment in 5, 10, etc. years; until then, you collect a set interest payment. The greater the risk the firms, the higher the interest rate. If an event occurs that increases risk (for ex.: bankruptcy or rumors of financial problems), investors may sell of their bonds at  below the face value. When a bond sells well below the face value, it is called a “junk bond.” While junk bonds have been around forever, Michael Milken (a Drexel executive) legitimized the widespread use of junk bonds. His theory was that the Federal Government would not let very large firms collapse, because of the potential damage to the economy. Milken gained a golden touch when Ronald Regan’s administration guaranteed loans to bankrupt Chrysler. Milken approved bonds were bought at pennies on the dollar, but valued at or near face value.

When you can nearly print money by assembling a new junk bond fund, demand can (and did) explode. Demand for Milken approved junk bonds far exceeded the number of “too big to fail” companies that had “junk” rated bonds. So, the definitions changed, the level of risk rose and the funds got bigger. Drexel not only bought bonds that were once good but dropped in value, they also produced new bonds that were “junk” from day one. Drexel fueled the “greenmail” market by providing cheap financing for corporate raiders, but also provided a “safe” yet profitable boost to pension funds, mutual funds and all sorts of mainstream financial instruments. At the close of the 80’s, the junk market faltered and then fell. Junk funds collapsed. Investors feared these funds, and then learned that they had contaminated the larger market, spreading panic and damage. Investigations were conducted, legal violations were found, Milken and others were indicted, and Drexel was shut down.

(1998) Derivatives – LTCM: Risk is the heart and soul of Wall Street. It determines how much interest you get on a bond and most other financial instruments. For decades, Wall Street looked for ways to limit risk and expand the number of investors. The Black-Sholes model was a financial model for creating a type of financial instrument known as an option (the right to a financial transaction, at some time in the future), and then adding other very specific assets to the fund that move in the opposite direction. By making a perfect combination of options and “hedging” assets, you have a “derivative” that produces a profit. While this model produced a consistent profit, it was not a large profit. But that could be dealt with by using leverage (borrowing money to buy more assets and multiply profits). The Vice-Chairman of Solomon Brothers, John Meriwether, left Solomon and build the world’s largest derivative fund, in partnership with Nobel prize-winning economists Fischer Black and Myron Scholes.

This powerhouse team guaranteed world-wide acceptance, and derivatives became a growing part of the mainstream world of finance. However, greater acceptance meant a bigger fund and still greater leverage, as new assets tended to produce lower returns than the last assets you purchased. Leverage increased from 2:1 to 10:1 to 100: 1 to 1,000:1 and beyond. A supercomputer was purchased to keep up with the speed of trading. According to Wikipedia, in 1998 the fund was nominally worth $4.7 billion, a fairly staggering amount in itself. But total borrowing for “leverage” was $124 billion. Even worse, the borrowed money paid for derivatives that were in themselves leveraged. In reality, the fund controlled $1.25 trillion in assets around the world. Because of the complexity of this fund, few investors seemed to be aware of this risk. Fewer still understood that the Black-Scholes model had an Achilles heel. The model didn’t work reliably during a financial crisis. In 1997 there was a financial crisis in Indonesia, which began to spread to other areas of Asia and in 1998 the Russian economy had a crisis. LTCM was heavily invested in both markets, and crashed. The world bank and other financial institutions work behind the scenes to defuse the now worthless assets to reduce the size of the financial crash. LTCM was closed.

(2008) Subprime – Bear Stearns: Collateralized Debt Obligations (CDOs) are another type of derivative. Here various loans and mortgages are put into a common bucket. As the loans are paid, revenue flows out of the bucket through multiple “spigots”. You can choose which spigot is right for you: very senior, senior, junior, etc. Each spigot has different rules, rates and priority. The most senior position will receive a lower percentage (for lower risk), but has the first turn at the spigot. And so on down the line. The most junior receives a higher percentage (higher risk), but only gets his chance at the spigot after everyone else. If things have not gone well that month, there may be little or nothing left. CDO fund managers believed that this risk adjustment mechanism made their assets more valuable. Buyers agreed, and the number of CDO funds grew.

Bear Stearns jumped into CDO’s with both feet. They build two large funds that blended subprime mortgages (think of them as “junk” mortgages) with other assets. They provided good returns, but then subprime began to appear on the nightly news in connection with financial failure. At first subprime and CDO’s were spoken of separately, but then panic spread as investors learned that subprime had spread and contaminated other assets (funds containing subprime, or funds that contained other contaminated funds). Indictments for the fund managers soon arrived from the Security and Exchange Commission. Interestingly, while the funds stated that subprime holdings were to be no more than 6-8% of assets, in reality it was nearer to 60%. Once again, undisclosed debt increased the damage. The funds were closed, and in a matter of days Bear Stearns was closed and sold off to JPMC.

As you can see, this cycle of exuberance and collapse repeats about every 10 years. In retrospect, it all seems so obvious and ever so avoidable. And yet it will probably happen again. There is an emotional element to Wall Street that mere rules and numbers fail to capture. Fund managers, and it would seem regulators, get carried away by the sheer magnitude of success, and questionable ideas are allowed to grow into economy crushing juggernauts. Caught up in the moment, governance is relaxed and otherwise highly respected individuals slide into illegal activities. But what can you, the humble project manager, do?

The PMO office of a financial firm cannot on its own stop these periodic collapses, but you can take steps to limit the damage. Basel III is a new framework for managing risk, and is in the early live testing phase. Other risk management guidelines are appearing as well. Do you see Basel III or other risk related projects in your 2012 project portfolio? Look for them, and prepare your project managers so that they can effectively participate in these projects. Ask department managers if they have planned any risk-management  projects in 2012. Look for new groups that have joined your firm, or highly publicized new hires. New high level hires and new departments often means new types of functions whose risk may not be well understood. It also mean new managers who  may not know the firm has  a PMO office, or how you can help them. Go out and look around. You might just do some networking and find a few new projects, or you might help protect your firm against the next big collapse! At least that’s my Niccolls worth for today!

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PMO Basics: Understanding Basel III

Posted on April 29, 2012 by

If you work in a financial institution, big changes are on the way. Lessons learned from the financial collapse of the past few years, has led to new thinking about how financial institutions need to operate. Or maybe it’s old thinking that has come back into fashion. In the years leading up to the collapse, we had a lot of growth and a lot of thinking about what limits growth. The answer, around the world seemed to be less regulation, fewer requirements for liquid assets in an emergency, and ever more complicated financial instruments to yield higher returns. Since the economy did collapse, this now appears to have been a less than perfect combination. In fact, the same combination of factors fueled the rise in world financial markets in the 20s that ended in the Great Depression. That economic event led to a number of regulations that prevented a repeat collapse for many decades. Today, some of the most critical regulations are being developed in Europe. The US government has agreed to adopt one of the most critical regulatory frameworks, Basel III. What is Basel III, and why is it so critical to financial firms (and project managers)? That’s exactly what we’re going to discuss today! Let’s dive in:

Basel III is a framework for bank regulation, named for the town in Switzerland where the “BIG 10” countries originally met. Basel III is a new set of guidelines that follows on from Basel II, which was developed in 2004. The core concept behind Basel III is that every financial institution needs to have the right amount of liquid, accessible assets for both day to day issues and for emergencies. The idea is simple, but the execution is quite difficult. Here are the three major components of Basel III:

  1. Liquidity requirements: Basel II generally required 2.5% reserves, but this obviously proved inadequate in the last financial crisis. Basel III increases this to 7.0%.
  2. Asset definition & testing: In  the last financial crisis, assets that were supposed to be liquid (easily sold or converted into cash) were found to be impossible to sell. Either they were not truly liquid, or they were blended with more difficult to price or sell instruments, especially subprime loans. Basel III will do more to define risk and test it… with periodic “stress tests” that simulate a financial crisis.
  3. Risk adjustment: The financial crisis was not brought about by too many high-quality  investments. Risky investments were made up of questionable assets that are either too complex to understand or too opaque to review caused the crisis. Basel III adjusts reserves based on risk. Financial institutions that want high-risk investments will less available cash to invest; institutions that choose lower risk investments will be able to invest more. How we identify and quantify risk now moves to the forefront of world finance.

In the US, regulators are still defining how Basel III will be applied. In December of 2011, the US agreed to apply Basel III to all banks, and to financial institutions with $50 billion or more in assets.  Which institutions will be included (will Basel III apply to private firms, how?),  and how international standards will be used to identify risk is still being defined. In March of 2012, 19 banks were tested, 15 passed. There are 7,400 commercial banks in the US, so this is just the beginning of a process that will take many years to complete. Banks which have not  passed a stress test will eventually be seen as having undisclosed or unacceptable risk.

Which brings us back to project management. These are huge changes. If you work for a financial firm, projects will be launched before and after ever stress test. New applications need to be developed to track and test fund behavior. Other applications will be created to give senior executives more visibility into the activities of their fund managers; when the next crisis comes, regulators are expected to deal harshly with senior executives who are not aware of how fund managers use the firm’s money. Training is needed throughout the firm, not just in trading and banking groups. By increasing the reserve and liquidity requirements for banks, groups with higher-risk  risk investments will look for ways to offset these requirements by reducing operating costs.

Basel III isn’t anything new, but it is big and it will bring big changes. Look at your project portfolios. If you can’t see a footprint for Basel III you should talk to department managers about their plans. While only 19 firms have been involved in stress testing so far, the thousands of other commercials banks will need to follow… soon.  Get ahead of this trend, and start building new projects or at least put placeholders in your portfolios. Planning now will definitely help to keep you on track when the Basel III wave hits your firm. And that’s my Niccolls worth for today!

Posted in Best Practices, Decision Making, Project Management Office | Tagged , , , , , | Leave a comment

Word From PEX Week European Conference…

Posted on April 23, 2012 by

Here’s an announcement from our friends at PEX!

April 23rd will see hundreds of process improvement professionals descend upon London for the annual PEX Week European Conference.  It looks like an exciting event but obviously being London based means it’s out of reach for many from outside of Europe.  Thankfully they’ll be providing a live blog of the event so that those unable to attend in person can still find out what’s going on and interact with speakers at the event.

Highlights (all times GMT):

  • Keynote speech – Equipping your business for all eventualities: Learning from the lessons of the recession and building a stronger organisation for the future by Connie Moore 24th April @ 10am
  • Keynote speech – BIG Data = BIG Opportunities! – Discover the Value of Data Analysis in Developing Customer Centric Process with Andy Jones 24th April @ 12.15
  • Live Q&A on Big data with Connie Moore and Andy Jones 24th April @ 1pm
  • Tweet jam on sustainable innovation 24th April @ 3.10pm
  • Keynote speech – Raising the competitive bar and securing Customer Gold by Steve Towers 25th April @ 9am
  • Live Q&A on Six sigma on steroids with Steve Towers 25th @ 1.15pm

To participate with the live blog simply click here to open up the chat window, or you can join in via Twitter by using the hashtag #pexweek

Live blog provided by the Process Excellence Network!

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The General Electric Turnaround: Why We Can’t All Be Jack Welch!

Posted on April 22, 2012 by

All rights: Reuters

Jack Welch is perhaps the world’s best known improvement guru. His transformation of GE not only took genius, it took guts and determination to convince a company that was doing pretty darn well that it had to do better. Not an easy sell! But he did push GE from “Good” to “Great” and became a legend in the process.  In the 20 years that Jack led GE’s, revenues rose from $30 to $130 billion and company value went from $14 to $410 billion. Quite an impressive record! Not surprisingly, each of us would like to be the next god of corporate improvement, and follow in Jack Welch’s footsteps. That may not necessarily be such a good idea. First, those footsteps were made by some pretty big shoes. There are more corporations than there are genius CEOs. Second, the unique combination of genius and opportunity that drove Welch’s doesn’t come by every day. The uniqueness of Welch’s success was a reflection of the uniqueness of GE itself. Today’s blog takes a look at when we can and can’t apply the GE model.

Whenever I hear a discussion about Jack Welch and GE, the discussion always turns to removing the least productive 10% of the organization. If you’re a one f the world’s super brands, replacing staff may not be a big issue. If you’re a smaller firm with less brand recognition, recruiting top talent from better known competitors may already be your greatest challenge. Let’s take a look at details of the GE transformation and see which parts of it are transferable to your specific firm!

Are you a conglomerate of businesses? A really critical piece of information in understanding GE was that it contained a large number of essentially independent businesses. Before Welch arrived, GE operated a vast number of businesses. Not surprisingly, some businesses were not world leaders. Some might undergo  improvement, but others would continue to be under performers…… perhaps because they were in markets with declining profitability. Businesses that were never going to be #1 or #2 in their filed had to go.  And that’s just what Welch did. He sold or closed business units that could not be exceptional.

If your firm is a conglomerate with many businesses, culling your businesses is a good place to start. Independent business lines can be closed without impacting other parts of the firm. If your firm only produces a single product (or a limited number of products) this may not work. Units within a larger business might be shut down, but that could affect its operations. You might outsource an expensive or unproductive process to reduce the drain on profitability. That’s a step in the right direction, but it falls short of shutting down a group; it especially fails to release management resources that can be focused on more productive product lines.

Is there too much bureaucracy or too little structure? When you’ve worked in a big firm, you understand how crippling bureaucracy can be. Conversely, working in a smaller firm can mean negotiating and then developing new policies and practices every time a new situation arises. Clearly, Welch had to deal with an advanced and entrenched bureaucracy. Lifting this constraint was a key to his strategy. When Jack Welch took over GE when it had more than 400,000 employees spread around the world. Not surprisingly, that meant a lot of confusing and contradictory regulations and rules. But what if you are not one of the world’s largest firms? Instead of dismantling bureaucracy your firm may be focused on building it… writing policy, training staff, measuring adherence to standards, establishing gatekeepers, and installing controls.

In a firm that is still in its early growth stages, or has recently gone through a merger or an acquisition, the process of establishing controls could be far more important than the elimination of restrictions. Most firms battle to do both, getting rid of restrictions where they are not needed, while adding them where they can be of value. Because GE was well established and self-satisfied, removing restrictions was more important to Jack Welch. For the rest of us, the removal of restriction is a slower process. Without the lure of a specific business plan, a corporate reformer has little leverage to remove barriers to productivity.

You have the firm’s attention, where will you lead them? Welch needed to shake things up. GE was profitable, but it could be far more profitable. Welch’s actions gave a slightly drowsy firm a good shake. Not enough to harm, just enough to invigorate. Welch wanted GE to be #1 or #2 in every business, requiring an alert staff to deliver their maximum effort. Contrast this with managers promoting “change for change’s sake.” These managers want to see changes, but are vague about their goals and the rewards for those who deliver it. The result is churn without direction, and often without measurable results. No firm should settle into stagnation, but before you order a firm to rev up its engine, you need to know where you are headed. Without that direction, managers expend energy and workers work harder, but long-term goals are not achieved.

Churn vs. improvement: As I said before, people most often remember Welch’s ongoing removal of the bottom 10% of their staff. Continuous improvement makes sense. Getting rid of lower performing workers makes sense. But cutting staff without a well-defined plan doesn’t make sense. Before you start cutting staff, you need the plan for the new organization. Individuals today who might not be considered the top performers might be the best for the new organization. Likewise, today’s top performers might not  all want to be in the new organization. You need to define the new organization, and your staff needs to see that plan. When you go to the market for new employees, the best workers will be hard to find if your firm develops a reputation for arbitrarily terminating staff. If you genuinely want higher performing staff, you shouldn’t be too surprised if better performing workers cost more than their under performing predecessors. These costs can be dealt with in a business with rising revenues and profitability. But what if you don’t have a business plan that will deliver greater profitability? Approvals for higher salaries will be difficult to justify, and even harder to approve.

Reward performance: If improvements are being delivered, what happens to the top performers? They get rewarded… a lot! While the bottom 10% is cut, the top 20% is heavily rewarded. The spectacular rise of GE provided money for rewards. If your organization does not significantly improve profitability, how will these performers be rewarded? When your staff (and the market) continues to work harder than the staff at competing firms, your best workers will leave. Of course, compensation is just one of the factors in worker loyalty. If your firm has a spectacular reputation, there is a value to having your name on a resume. Google is known for the world-class  chefs at it (free) cafeteria, and for its other “social” programs. If you don’t have the top reputation in your industry or the best benefits, you can expect a higher premium in compensation to attract the best talent.

How does it all fit together: GE was a unique  firm in a unique  position. Jack Welch carefully leveraged the tangible and intangible assets of GE to recruiting and retaining staff. To keep up with his transformational goals, Jack’s plan required the termination of over 112,000 employees in the first five years of his tenure as CEO (25% of the firm’s staff). In most firms, this level of change (and risk) could not be sustained… unless the business plan has an equally massive benefit. If your organization is driving change, is that change part of a singular corporate goal? Does that goal cascade across your firm to deliver staff and procedural changes? If you want improvement on the scale that Jack Welch drove, you need to line up these five factors…

  1. A”BIG”  business goal: Different improvement philosophies use different names, but let’s call this the “big idea.” You need a big idea in order to drive big changes. Even without a top-level  plan, change can (and does) happen. But the degree of change will be more limited. Your plan will be stopped by more internal gatekeepers because they have not been told by their managers that your plan has priority over their role as “protectors” of the organization.
  2. Fewer businesses: If you did nothing more than get rid of businesses that lose money and cannot quickly be made profitable, your firm would be improved. Not all firms have multiple lines of business, but whatever change your plan is driving must free up some of their time so that they can deal with the “big idea.”
  3. Churn in staff: Every firm has a unique brand. The stronger the brand, the more you can churn your staff and still attract the best talent. But don’t just churn your staff, use turnover to move towards a new model. If you turn your group into a dynamo of productivity, but you have no new goals for your re-invigorated staff…  you may just create boredom that undermines productivity.
  4. Reduction of bureaucracy: Lastly, you need to sweep away unnecessary bureaucracy so that the new organization can be agile and effectively pursue new opportunities.
  5. Rewards: Not just the top officers, but all the top performers who drove change needs to share the rewards.

We can’t all be Jack Welch, nor should we all try. Jack’s model for change requires a powerful business goal that the entire firm can follow. Perhaps you can use just a small part of the GE model, but it is a self-supporting model that requires the support of more than a single business group to make it successful. When all of these elements work together, you just might be able to be the next GE, at least that’s my Niccolls worth for today!

Posted in Best Practices, Decision Making, Expectations and Rewards, Improvement, Continuous or Not, Project Management Office, Uncategorized | Tagged , , , , , , | 2 Comments