Building the Target Operating Model for an economy
Submitted by Lee Fig on Sun, 2010-11-21 20:04
Recently I have been reminded about the concepts that one has to grasp in order to build, evaluate, purchase and sell financial structured products. Structured finance denotes the art (and science) of designing financial products to satisfy the different needs of investors and borrowers as closely as possible. This needs to be understood in the context of Target Operating Model (TOM) and respective business processes.
Recent developments in Ireland reflect, in a sense an extension specific technique and operation of the financial intermediation business - when it goes wrong. In fact, it's traditional banking activity, i.e. designing loans to provide firms with funds and deposits to attract funds from retail/private investors, along with managing the risk of a gap in their payoffs, was nothing but the most primitive example of a structuring process.
Of course this was fuelled by what we now to be a property bubble. Nowadays, the structured finance term has been provided with a more specialized meaning, i.e. that of a set of products involving the presence of derivatives, but most of the basic concepts of the old-fashioned intermediation business carry over to this new paradigm. Building on this basic picture, Ireland like other countries fell into the hotpot trap involved with making products more and more attractive to investors and borrowers.
The motivation is the same i.e. to provide funds to borrowers to enable someone to do something that could not be done in any other way (or in a cheaper way) under the regulations. So long as risk was not compromised once the numbers had been crunched this business model remained unbroken.
To explain, take the simplest financial product you may imagine, a zero coupon bond, i.e. a product paying interest and principal in a single shot at the end of the investment. The investor’s question is obviously whether it is worth giving up some consumption today for some more at the end of the investment, given the risk that may be involved. The Irish borrower’s question is whether it is worth using this instrument as an effective funding solution for his commercial property development say.
What if the return is too low for the investors or so high that the borrower
cannot afford it? That leads straight to the questions typically addressed by a TOM providing for a more effective structuring process with risk being a core principle:
Maybe the maturity is too long, so what about designing a
different coupon structure? Or maybe investors would prefer a higher expected return, even at the cost of higher risk, so why not make the investment contingent on some risky asset, perhaps the payoff of the project itself? If the borrower finds the promised return too high, what about making the project less risky by asking investors to provide some protection?
All of these questions, in ideal world, would be addressed by a TOM to mitigate risk for lender, borrower and institution or in the case of Ireland the sovereign nation. It would lead to the definition of a “structure” for the bond as close as
possible to those needs as opposed to being a product that effectively retrospectively fit those needs/requirements. So long as the risk management processes did not flag the transactions the numbers made sense.
But the problem with this assumption is now obvious. That the "structure" is probably be much more sophisticated than any traditional banking product. And in the absence of any satisfactory operating model the production process of a structured finance tool involves individuation of a business idea and the design of the product, the determination and analysis of pricing, and the definition of risk measurement and management procedures was fatally flawed.
Going back again to the comparison with banking, the basic principles were already there: design of attractive investment and funding products, determination of interest rates consistent with the market, management of the misalignment between asset and liabilities (or asset liability management, ALM). Mostly the same principles apply to modern structured finance products: how should we assemble derivatives and standard products together, how should we price them and manage risk? These are all questions that my be analysed and modelled using complex equations but fundamentally our resolved by the business's operating model. An economy is no different.
Ironically, for Ireland this notion has become even more prerequisite in order for it to recover. The hard part of the job without there being a new or updated TOM would then be to convince or at least explain the structure, as effectively as possible, to the investors and borrowers involved, and convince them that it is made up to satisfy their own needs. The difficulty of this task is something, it appears, that we are going to share. We will need a model that provides great transparency. What are you actually selling or buying? What are the risks? Could you do any better?
A sound TOM will force asking the right questions that will lead to an answer that will be found to be straightforward, almost self-evident: why did not I get it before? It is more than simply the replicating portfolio. The bad and good news is that many structured products like lenders and borrows, have their own replicating portfolios, peculiar to them and different from those of any other. Bad news because this makes the design of a taxonomy of these products an impossible task; good news because the analysis of any new product or economic recovery may be enhanced by and indeed require a principled business operating model. Defining the blueprints for the new model is the challenge not just but for Europe that will likely have ramifications on the Euro, Basel III and beyond.
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