The massive fraud at AIB's US subsidiary Allfirst shows how internal controls are always playing catch-up, suggests Ray Kinsella. It is a gap that will have to be bridged
It will take some time before all the investigations now under way are completed. Moreover, a rush to judgment is never a smart idea. Nevertheless, there are already a number of points about the events at AIB's US subsidiary - Allfirst Bank - that are clear.
Some of these have to do with the failure of the internal control systems and the likely effect on AIB Group. Some of them have to do with the increasing difficulty with all banks of managing risk within the context of a globalised financial market of unprecedented complexity. The latter raise issues regarding the vulnerability of the global financial system - of which Ireland is a very small subset - to a global systemic shock.
AIB has acknowledged that there was a failure in the internal control systems within Allfirst Bank. This was the problem which brought about the collapse of Barings Bank some years ago - an event which, despite the relatively small size of Barings, sent a shock wave through the entire global banking system. One rogue trader decimated the entire capital base of one of the oldest British banks.
Comparisons between Allfirst and Barings are totally overstated. To begin with, Baring Singapore subsidiary, within which Nick Leeson worked, was a small operation which generated for a short period enormous profits.
Secondly, Barings management were manifestly culpable for not acting on clear and obvious efficiencies in the Internal control systems in Singapore.
Thirdly, the management as a whole was clearly out of its depth in understanding the markets in which Nick Lesson was trading: they chose to ignore the poor quality of the earning stream reflected in the fact that one small unit could generate such a high proportion of total profits.
None of these arguments applies to the Allfirst bank. To begin with, AIB Group, in pursuing during the 1990s a strategy of global diversification, has developed, in Maryland, a robust and profitable organisation. Secondly, while the impact of the alleged fraud is significant, in terms of the impact on AIB's capital base, it still leaves the group very well capitalised in terms of international benchmarks.
Thirdly, the alleged fraud was - unlike the Barings case - highly complex, but crucially it was picked up by the bank's control systems- albeit not until a significant amount of damage had been done. The situation was significant but certainly far short of critical.
Perhaps the most important difference is the manner in which management has, to date, handled the debacle. The proactive approach by group management, which has been highly transparent to the markets, will have gone some way to reassuring large institutional investors. The decision to take the capital charge in the current year was absolutely correct.
Having said that, the breakdown in internal controls in Allfirst should not have happened. There will be collateral damage in terms of market perception. Like most large international banks, AIB Group has a highly sophisticated risk-management system. Some of the questions that need to be asked will focus on the management process and some on how the bank's settlements procedures could have been subverted to such an extent.
The reality is that internal controls in all banks are continually playing catch-up with both financial and technical innovation within the markets.
A shock such as this has become increasingly probable within a market environment in which internal control systems increasingly lag behind the complexity of the markets which they are intended to monitor - and the regulatory authorities generally arrive a little breathless and a little late.
Certainly supervisory authorities are increasingly monitoring the quality of internal controls but it is not easy to see how this gap can be bridged. Moreover, the prospective risks embedded in this environment are exacerbated by the increasing scope for externally generated attacks on a banking system whose central nervous system is technology dependent and therefore vulnerable to subversion.
There is an additional issue which the Allfirst shock throws into sharp relief. In an environment of increasingly concentrated, and integrated, financial markets there is, quite simply, nobody in charge. The long-term capital management crisis of the late 1990s, and the Asian banking crisis, would have been immeasurably worse in their impact on financial markets had the New York Fed not stepped in. That's not its job; it is not responsible for maintaining the stability of the global financial system. Then again, neither is the IMF.
The Bank for International Settlements plays a pivotal role but it does not have a global mandate. Nor does it have the policy instruments needed to contain a full-blown systemic crisis. And the European Central Bank is only now beginning to develop a supervisory capability. Responsibility still rests primarily with National authorities whose banks trade on global markets.
This fragmentation of responsibility is, quite simply, scary. It may not be so easy to deal with the next crisis - and there will be one as we head into prospectively a period of low economic growth and heightened political risk. It's poor comfort for AIB shareholders, but at a global level the Allfirst shock may have the effect of concentrating minds.
Ray Kinsella is Professor of Banking and Finance, and Director of the Centre for Insurance Studies, at the Michael Smurfit School of Graduate Business Studies at UCD