Counterparty Due Diligence Craig MacDougall Head of Credit ABN AMRO Futures Ltd. London

1. Counterparty Due Diligence Craig MacDougall Head of Credit ABN AMRO Futures Ltd. London

2. Subject Matter Due Diligence • Why? • How? • How Far Do We Go? • What Questions To Ask? • Where to Look For Possible Problems? • How To Keep Up-To-Date • When To Review • Trends and Information Sources

3. 'Don’t try to teach your grandma to suck eggs!' Definition: - • Charles Earle Funk says in “Hog on Ice” (Harper & Row, New York, 1948). “To teach one’s grandmother to suck eggs – To offer needless assistance; to waste one’s efforts upon futile matters; especially, to offer advice to an expert. This particular expression is well over two hundred years old; it is just a variation of an older theme that was absurd enough to appeal to the popular fancy. One of the earliest of these is given in Udall’s translation of ‘Apophthegmes (1542) from the works of Erasmus. It reads: ‘A swyne to teach Minerua, was a prouerbe, for which we sai: Englyshe to teach our dame to spyne.’” That last bit was about an expression, don’t try to teach a dame to spin.

4. COUNTERPARTY DUE DILIGENCE WHY?

5. COUNTERPARTY DUE DILIGENCE - WHY? ANSWER:- SCANDAL =

6. COUNTERPARTY DUE DILIGENCE - WHY? Or even

7. Non - Ferrous - Fabricated documents at centre of Allied Deals case, prosecutors say. Banks slow to catch on to metals trading scam - At least US$600M lost. COUNTERPARTY DUE DILIGENCE - WHY?

8. ENRON SCANDAL 17Feb2000 GHANA: Ashanti Goldfields reaches rescue deal as seven board members go. COUNTERPARTY DUE DILIGENCE - WHY?

9. COUNTERPARTY DUE DILIGENCE - WHY? In many ‘loss given default’ situations, lack of effective due diligence can be a significant factor.

10. How to KYC • Client Visits. • Financial Reports and Accounts. • Compliance, Legal Checks and MLRs. • Market Knowledge and Developments. • Stock price performance (KMV etc). • The WEB. • Regular Reviews.

11. How Far Should Due Diligence Go? A. “As far as necessary to be comfortable!”

12. What are the vital questions? A. Clearly this is dependent on the type of risk and the type of client... • Do you know your customer? • Does their business make sense? • Can they support the risk? • Is the legal documentation enforceable?

13. Client Visits (what to consider) • Make real use of a client visit. Don’t just sit in the CFO’s office! • Walk through systems. • Speak to staff. • Inspect & ask for copies of other bank or broker facility documentation or get a letter of confirmation... don’t allow your firm to be ‘Dutch-auctioned’.

14. Client Visits (what to consider) • Try to gain a good understanding of the client’s business. • Do you feel that senior management are effecting good control? • Discuss their risk management processes? • How do they control Operational Risk? • Do they have a DR Site? - really?

15. Client Visits (what to consider) • Which VaR or DEaR method is used - historical simulation, parametric or Monte Carlo? • Are the input variables sensible - confidence level, holding period, volatility, correlation, forward pricing? • Are abnormal/tail event risks catered for?

16. Client Visits (what to consider) • Are any other portfolio risk management methods used and do they make sense? • Do risk controls extend to limits by region, product, tenor and basis? • What stress testing is performed?

17. What Can Be Learned From Recent Events? • Like price volatility, ratings downgrades can trigger huge calls… • In the Californian power crisis last year some firms had margin calls of US$900mn in a single day, even when fully hedged! • ...so how much risk capital and liquidity resources does the counterparty have?

18. Financial Reports and Accounts • Analyse the financial position thoroughly. Request clarification of unusual items or notes. Look out for ‘dodgy deals’ e.g. round trip trades or granting options to raise premiums. • Get bank and third party references if necessary. • Get a feel for the management. What does your instinct tell you?

19. Financial Reports and Accounts • FAS133; FAS141 & 142 re derivatives; goodwill, other intangibles and business combinations… • ...serious impact on firms income and equity base for impairment or trading assets may be overstated.

20. What are the Compliance & Regulatory Implications? A: Management has the responsibility to effect proper control over its business. This means complying with regulatory requirements, company compliance rules and internal controls.

21. Market Knowledge and Developments • Make contact with counterparts at other firms, not just at home but overseas too. Risk groups such as PRMIA and FOA are an ideal way to do this. • Have a good channel of communication with traders. • Get access to as many information sources as possible.

22. How often should you review? A. Regularly... Ideally shortly after inception and then at regular intervals, at least annually. Again, may vary. • Ensure accounts come through on time. • Ensure covenants are met.

23. Future Trends? • Credit due diligence is deepening and widening in scope in order for the bank or broker to know its customer. • Some customers have prepared highly detailed information packs on relevant areas of their internal control processes.

24. Where can third party information be obtained from? A. There are some very useful providers of free information and many that charge for their services. See the attached non-exhaustive list.

25. Third Party Information Websites