THE FINANCIAL SERVIVES

The Responsibilities of the Financial Services in the misuse of Financial Derivatives



Chapter 1: Introduction

Overview

Financial Servicess are accustomed to looking at risk by examining balance sheets? ledgers and income statements and gaining a general “feel” for the nature of the business that the firm is in - plus perhaps some knowledge of the financial risks of any securities the firm has issued or holds. Standard auditing theory does not sufficiently address the problems that arise when Financial Derivatives are used - in particular the way that risk can be leveraged and made to change their shape. Positions previously established are easily altered by adding Financial Derivatives. The leverage inherent in virtually all derivatives is a horsepower that is poorly represented by notional amounts and even market values. The power to take short positions -so easy in any financial derivative market - means that even the direction of risk is sometimes not so obvious. Hidden and subtle risks have a way of arising in complex systems more easily than in simple ones. (Costa 2006: 95)

While this suggests that auditors need to build their skill? it does not mean they need to abandon their core strengths. As ever? the auditor naturally must be of a skeptical disposition. He must question? dig and question again. He must never be satisfied with part of the answer. He must be sensitive to conflicts of interest and breaches of security in an organization. He must not hesitate to question numbers that on the surface appear normal and indisputable. Nowhere will these traditional strengths matter more than when an organization uses Financial Derivatives. (Kite 2005:20)

Cases such as those of the Barings Investment Bank bankruptcy in Great Britain? Metallgesellschaft AG (MG) in Germany? the large losses of Allied Irish Bank (AIB) in Ireland? three of the six largest bankruptcies in American history--WorldCom? Enron? and Global Crossing? which occurred between December 2001 and July 2002? the near collapse of the Long Term Capital Management (LTCM) hedge fund? the Amaranth Advisors LLC in US which recently lost about US$6 billion in single week on the natural gas futures in September 2006 and the Italian Bank Italease which in 2007 sent tremors through Milan's banking fraternity and exposed the hidden dangers of exotic credit instruments have elevated the popular notion that the use of derivatives are indeed the culprit that brings about massive failure and loss of enormous sums of money by companies and government entities.

However? this dissertation firmly believes that derivatives did and do not cause firm failure or large losses? but the misuse of this financial instrument. Therefore it is the researcher's belief that an Financial Services with the right knowledge and attributes should have detected trouble and highlighted it. The cases of bankruptcy and severe financial loss reportedly due to derivatives need to be investigated to pinpoint the root cause of these incidents and to understand where the Financial Servicess where in all this and how he/she could have avoided or helped to avoid such ...