Tuesday, October 5, 2010

Auditing Derivatives: Think of what can go wrong Middle Office (Controlling Group)


This article appeared in The Malaysian Accountant journal, Aug&Sep 2010 issue

The previous article showed that thinking of what can go wrong can shape the auditor’s mindset to better detect areas of weakness, more so when reviewing activities in an investment bank trading predominantly derivative instruments. After discussing the trading floor at length in the last article, we now move to the middle office, a significant function of the bank.

The Middle Office
The middle office, being the largest section in the bank comprises the following essential units:
-          Controlling Group (P/L and Risk)
-           Risk Management
-          Model Validation
-           Independent Price Valuation (IPV)
Different banks tend to organise the individual units differently. In some banks, the Controlling Group is combined with the IPV group to be more effective in controlling traders’ activities and to avoid redundancy. Other banks may prefer the IPV group to maintain its independence and report directly to management.  Some banks also tend to have the Risk Management and Model Validation in the same unit. Nevertheless, we will explore the above units individually. This article will focus on the first unit, the Controlling Group.

The Controlling Group (P/L and Risk)
This group, as the name suggests, acts as controller for the bank. It controls what goes into the P/L trading book and reports daily profit and risk on trades. Besides channelling trades to relevant books, it also ensures that the systems adequately capture trades for computation of profit and risk.
The Controlling Group deals with almost every department in the bank. For that purpose, this group is not to be underestimated. Many potential problems can be unearthed and solved right here, before they get further.  
But what could go wrong?