
Effective Product Control
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Content
Preface xiii
Acknowledgements xv
About the Author xvii
PART ONE Working in Product Control
CHAPTER 1 An Introduction to Product Control 3
The Emergence of Product Control 3
The Purpose of Product Control 3
Different Types of Product Control 5
Skills, Qualifications and Experience 6
Organizational Structure 8
The Desk 10
CHAPTER 2 Changing Landscape of Product Control 15
Offshoring 15
XVA 19
Greater Levels of Capital 19
Greater Focus on Liquidity 20
Notes 21
CHAPTER 3 Key Stakeholders 23
Front Office: Sales and Trading Desk 23
Chief Operating Officers (COOs) 25
Operations 26
Middle Office 27
Market Risk 28
Financial Reporting 29
Management Reporting 29
Finance Change 30
IT 30
Operational Risk 32
Regulatory Reporting 32
Accounting Policy 34
Tax 34
Audit 36
Finance Shared Service 37
Summary 37
Notes 37
PART TWO Technical Skills
CHAPTER 4 Accounting Standards: Recognition and Measurement 41
IAS 39 Financial Instruments: Recognition and Measurement 42
IFRS 9: Financial Instruments 60
IFRS 13: Fair Value Measurement 66
Notes 71
CHAPTER 5 Market Risk 75
What Is Market Risk and How Is It Generated? 75
How Is Market Risk Measured by a Bank? 77
Note 85
CHAPTER 6 Pricing Financial Instruments 87
How to Approach the Pricing of a Financial Instrument 87
Pricing Examples 89
Notes 105
CHAPTER 7 Internal Control 107
What Is Internal Control? 107
Establishing an Internal Control Framework 110
Example of Front to Back Internal Controls 117
Notes 122
PART THREE Profit and Loss Controls
CHAPTER 8 System Feeds, End of Day Rates and Profit and Loss Estimates 127
System Feeds 127
End of Day 129
End of Day Rates 130
P&L Estimate 135
Note 136
CHAPTER 9 Review of New and Amended Trades 137
New Trades 137
Amended Trades 152
Notes 164
CHAPTER 10 Review of Mark-to-Market P&L 165
Defining Mark-to-Market P&L 165
Attributing MTM P&L 166
Risk-Based P&L Estimates 170
Changes in the End of Day Prices 173
When to Validate the MTM P&L 176
CHAPTER 11 Funding, Fees and Charges 177
Funding 177
Fees and Charges 185
Note 187
CHAPTER 12 Profit and Loss Adjustments 189
The Need for P&L Adjustments 189
Controlling P&L Adjustments 190
Notes 194
CHAPTER 13 Profit and Loss Commentary 195
Who Is the Reader? 198
When Is P&L Commentary Required? 198
CHAPTER 14 Profit and Loss Reconciliations and Sign-Offs 201
Flash vs. Actual 201
Desk P&L Sign-off 203
P&L Reconciliation 205
PART FOUR
Valuations
CHAPTER 15 Independent Price Verification 209
Components to IPV Process 210
Note 224
CHAPTER 16 Valuation Adjustments 225
Why Valuation Adjustments Are Required 225
Bid-Offer 225
Day 1 Reserves 234
Model Valuation Adjustment 234
XVA and Collateral Agreements 235
Recording and Reporting of VAs 239
Notes 239
PART FIVE Balance Sheet Controls
CHAPTER 17 Balance Sheet Substantiation and Analysis 243
Substantiating the Balance Sheet 243
Frequency of the Balance Sheet Substantiation 248
Evidencing the Balance Sheet Substantiation 249
Unsupported Balances 249
Lines of Responsibility 255
CHAPTER 18 Dividending of Profit and Loss and FX Selldown 257
CHAPTER 19 Controlling Nostros 261
Introduction to Nostros 261
Controlling Nostros - Cash Breaks 262
Risk-Weighting Cash and AVE breaks 266
Provisioning for Nostro and AVE Breaks 267
Notes 268
PART SIX Financial Accounting and Reporting
CHAPTER 20 Financial Accounting Entries 271
Financial Accounting Entries 271
Chart of Accounts 284
Accounting Rules Engine 286
Notes 289
CHAPTER 21 Financial Reporting and Note Disclosures 291
Context of Financial Reporting 291
Profit and Loss 293
Balance Sheet 295
Netting 297
Fair Value Hierarchy 304
Notes 309
PART SEVEN Supplementary Controls
CHAPTER 22 New Product Proposals 313
Starting Line 313
The Review 314
The Sign-Off 319
CHAPTER 23 Rogue Trading 321
The Forefathers of Rogue Trading 321
The Fallout from Rogue Trading - The Bank 323
The Fallout from Rogue Trading - The Industry 325
Going Rogue 325
UBS Rogue Trading Incident, 2011 327
Notes 343
Index 347
CHAPTER 1
An Introduction to Product Control
The Emergence of Product Control
Finance within banking is unlike finance in most other types of industries. In most non-banking companies, the finance team is separate from the producer. For example, in a manufacturing company the finance department is not on the shop floor, and in a retail company it is not in the stores. Most likely, finance is housed in the head office.
In these industries, the value of the product is not often in dispute. Usually the cost of sales and production, or margin per unit, is known and the revenues are the function of a simple calculation. There is also often a team of management accountants providing information to the product line managers on the results of their business and assisting in analytics on those results.
In banking, it is not that simple. Finance is more integral to the production because the products banks deliver are financial. In the 1990s, with increasing volumes of trading, a greater pool of financial instruments and higher levels of complexity, it was necessary for banks to establish a dedicated function within finance to control evolving sales and trading desks. With that, management accountants within finance morphed and grew into a function called product control, which came to dominate large swathes of finance, establishing footprints all over the developed world and later on, the developing world.
Over the past decade, these large swathes have been migrating from the more expensive financial centres such as London, New York, Tokyo, Hong Kong and Singapore, to cheaper locations such as India, Poland and the Philippines. This change has presented opportunities for aspiring workers in the developing nations and presented uncertain career paths for those remaining in the shrinking financial centres.
We will look at this trend in more detail in Chapter 2.
The Purpose of Product Control
Product control is the face of finance to the sales and trading desks in a bank. They provide financial control and transparency through (Figure Figure 1.1):
- Providing a profit and loss statement and balance sheet which is accurate and timely;
- Providing meaningful insight into the desk's financial results;
- Supporting the desk in the execution of their business strategy; and
- Evaluating and integrating new products into the financial environment.
Product control's purpose is executed through a series of controls across the P&L and balance sheet, many of which are performed daily. On top of these controls, product control's financial acumen and understanding of the bank's systems can be used to support the execution of the desk's business strategy. This includes providing insight into drivers of financial performance, reviewing the desk's use of legal entities within the banking group and assessing the efficiency of process workflows.
Figure 1.1 The purpose of product control
The centrepiece of the product control role is the daily P&L (Figure 1.2). If you aren't familiar with this term, it measures the income and expenses for the sales and trading desks. If the sum of the income from trading activities, client sales and trading expenses is greater than zero, a profit is reported, otherwise a loss is reported.
Figure 1.2 The P&L
We will explore the controls that product control normally execute in greater detail throughout Parts III through VII of the book.
Different Types of Product Control
Before we can explore the role of product control further we need to be aware that not every organization will share the same mandate for their product control function. Although there will be exceptions to this, we can broadly categorize the function into one of two types:
- P&L only
- P&L, balance sheet and financial reporting.
P&L Only
The P&L-focused role is, as its name suggests, focused purely on the P&L. In firms across the industry this function may also be labelled as middle office. The review and substantiation of the balance sheet and financial reports are performed by a separate team(s) within finance.
There are benefits and drawbacks for any organizational structure. There are two main benefits to this model. First, it relies on a team with a narrower skill set, which can improve the control framework as the product controller does not have to be an expert in an excessive number of disciplines (accounting, risk management, financial reporting, etc.). Second, as the skill set is narrower it should be easier for the firm to hire and develop their talent.
The primary but manageable drawback to this structure is that a single team is not controlling all the financial aspects of the desk and weakness in the control framework arises when the roles and responsibilities of the different finance teams are not clearly defined and understood by all staff.
For example, the product controllers for the credit trading desk are aware of a late trade booking for 31 December (financial year end) that has missed the end of day report batches that are used to populate the P&L reporting system and general ledger (GL) for financial reporting. The product controller determines the trade has an immaterial impact on the P&L so decides not to adjust the P&L.
Although the trade had an immaterial impact on the P&L, it had a material impact on balance sheet usage, which the financial controllers will not be aware of. Consequently, the firm's year-end reporting misstates not only the balance sheet size and shape, but also the capital ratios, as the risk-weighted assets (RWAs) did not take this late trade into consideration.
This drawback can be compensated for by having clear roles and responsibilities and up-to-date standard operating procedures (SOPs) for each function. These documents make clear the control framework which the firm has in place for each desk.
Each task and responsibility should be documented extensively and refer to what is a control exception and when that exception should be escalated. In this example, the SOPs could require product control to adjust the month-end financials (both P&L and balance sheet) for every late trade.
P&L: Balance Sheet and Financial Reporting Focus
A broader version of product control includes responsibilities which cover the P&L, balance sheet and some financial reporting for the bank.
This product controller is aware that changes in the balance sheet are the driver of P&L performance and as such it is critical that the balance sheet is reviewed, substantiated and understood.
This product controller will perform the same functions as the P&L-only controller in addition to the following tasks:
- Review and substantiation of the balance sheet
- Advising the desk on the accounting treatment for their transactions (if further expertise is not required from accounting policy)
- Assisting financial reporting in their review of the financial reports, including note disclosures
- Populating the GL with any necessary financial accounting entries.
As product control cover a substantial portion of the control framework assigned to finance, the bank benefits from a single team monitoring all aspects of the desk's financial performance (i.e., the P&L, balance sheet and financial reporting). This set-up should ensure both the P&L and balance sheet are aligned and that by seeing the full financial picture, issues are more readily identifiable.
The main drawbacks of this structure relate to the breadth of responsibilities being undertaken. As the product controller needs to be skilled in many more disciplines than the P&L-only function, it can be more difficult to recruit and develop talent. Additionally, so many responsibilities may cause some to be neglected.
As before, these drawbacks can also be compensated for by having clear roles and responsibilities and complete standard operating procedures.
For the purposes of this book we will focus on this type of product control function.
Skills, Qualifications and Experience
Product control has historically employed candidates with varying levels of experience but one of the most common recruitment styles of banks has been to employ candidates who, after completing three years of work experience in an accounting firm and passing their accounting exams, have qualified as chartered accountants. These chartered accountants would then be brought into the product control function and be trained up to control the sales and trading desks.
Over time, these candidates would gain the necessary experience to move through the product control ranks by becoming senior product controllers and then product control managers.
Accountants who, for various reasons, have decided not to train in accounting firms are also very prevalent in the product control ranks. These candidates commonly spend their qualifying period working within the financial services sector at banks, fund managers, credit rating agencies and so on. This means they have different, but equally valuable, experiences to bring to product control.
Once in product control both sets of candidates can further their qualifications and skills by taking postgraduate courses.
Table 1.1 lists the product control hierarchy and the typical experience, qualifications and skill sets that you could expect to...
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