Lombard Risk earlier this week made a formal announcement to the London Stock Exchange about the relatively small impact of the credit crunch on its business so far, but I thought it would be helpful for our stakeholders to hear more about this in my own words in an article I have just written which is reproduced after this paragraph. This makes today’s blog entry much longer than usual, but so be it. I need to point out that this is my blog alone, just as what I say in an investor meeting or a chat with a staff member or customer would be my words alone. Although of course I talk frequently on these subjects with my board, these should therefore be taken as my thoughts only and not a formal board position.

The speed of the worldwide liquidity crunch has been stunning and at times almost impossible to believe. Three weeks ago the world was staring into the abyss of a catastrophic systemic meltdown. This seems to have been averted by massive Government action on a co-ordinated basis between major countries. But the fact is that within a matter of months we have gone from a system where central banks acted as a lender of last resort to one where central banks are the main provider of liquidity to all banks because banks will not lend to each other and there have been massive contractions also in commercial paper funding. The unwinding of hedge fund positions and other deleverage effects has given rise to daily volatility comparable to previous annual volatility (witness the Pound going from USD 1.63 to 1.52 and back to 1.59 in 24 hours on 24th October). Stock prices have gone down very heavily as the effect on the real economy has now become very apparent.

We now face calls for a new world order and this will be determined largely by politicians and policy makers. The real danger is that there will be a backlash against bankers for causing the whole crisis when in reality politicians and regulators must share some of the blame. However good the market information of Goldman Sachs or the economics department of Citigroup, individual institutions can never have the same ability to gather information as the authorities in a country who gather information from all banks and market participants.

Governments and regulators are powerful. They have access to information, they can guide and if necessary they can arm-twist. They often do in Financial Markets, an example being the UK FSA a few years ago being very assertive in ensuring more timely documentation in derivative markets which has been followed through to create greatly safer markets for instruments like credit derivatives. Another example was the UK Government forcing banks not to charge for the use of each others' ATMs. So Governments clearly have the power to give very strong guidance over certain types of activity, and if necessary they don't hesitate to use it. But they all failed to realize that imprudent lending to individuals and banks' standards of verification of personal income would become a major systemic issue rather than just an issue of imprudent banks losing money. Why was that - because banks became so efficient at originating this type of risk and then repackaging it that the losses fell on many more people and in far larger amounts than on the originators themselves. Systemic risk is most definitely an issue for Governments and Central Banks not for individual bankers. But these Authorities didn't identify in time how big a bubble banks had managed to create, or if they did they didn't take steps to deflate it gently.

Additionally if Central Bankers didn't know or shout loudly enough, it also suited Governments to acquiesce because economic growth accompanied by low headline inflation rates is what bolsters politicians' credibility and gets votes. It suited Governments to take the credit for years of economic boom which caused a property bubble and huge increases in paper personal wealth. Now that the property and related securitization bubble has burst and much of this paper wealth is gone, it is of course expedient to lay the blame for the resulting bursting of the bubble on the imprudence of the banks that we as taxpayers have had to bail out. Success has many fathers yet failure is always an orphan. Yet we surely can't just blame the banks but need to blame the Governments and Central Banks for not sounding much earlier warnings on this systemic threat despite having much more access to information than individual banks about what was really going on. So it seems to me that what clearly happened is as follows:

1. Banks became very good at the "originate and distribute" model, partly pushed in that direction by the capital treatment being vastly better than holding assets on their own books.

2. As assets were repackaged there was less incentive to ensure high credit underwriting standards. If your customer is happy with what he buys there is little incentive to improve the product.

3. The repackaging of securities was done professionally but institutional investors started to relax their standards by investing based on rating rather than fundamental analysis. Should you blame the salesman for mis-selling or the buyer for buying something he hasn't analysed properly ?

4. Internal capital models in the Basel 2 banking regulations necessarily had internal credit ratings enshrined in their methodology. How could a regulator challenge a bank's internal ratings for such paper when it could point to the rating agencies giving the issues very high ratings.

5. The rating agencies had inadequate models to stress test the impact on structured products such as CDOs or if they did have them they failed to apply appropriate stress tests; if they had applied stress testing of even one quarter of the market moves that have taken place they could never have given such high ratings. They were very highly paid for doing such ratings, so were inherently somewhat conflicted in not wishing to kill the goose that laid the golden egg.

6. The Authorities either failed to compile appropriate data to aggregate what was happening or, if they did, failed to interpret it properly to see the increasing systemic risk that this property bubble and efficient securitization presented. In the specific case of the UK this may have fallen between the cracks with the FSA having all the bank specific data and the Bank of England only having overall data.

Any predictions in such a market can look laughably out of date in hours let alone days or months. But here is what I think may happen :

1. There will without any doubt be changes in bank regulation, both information provided and how proactive bank regulators are with banks - less "light touch" than before. Whether these changes will shut the stable door after the horse has bolted is irrelevant - there will be tightening of regulation in all major countries and on a very co-ordinated basis.

2. There will be lots of criticism of the role of derivatives particularly in the US but at the end of the day this will be seen to be misplaced as these play such an important part in allowing risk to be transferred in a very clear legal framework. Any changes will be limited to more detailed reporting requirements and ensuring more controls on inappropriate mis-selling.

3. The more esoteric structured securitization products like CDO² will die a death owing to lack of market demand for them rather than regulation.

4. More will be reported to regulators, but in turn Central Banks will be asked to revise the statistical information that they publish to include more in the way of scenario analysis and stress testing of the whole system. This will cost more to do, but the cost will be peanuts compared with the cost of the catastrophe that has been presided over. One such risk factor that should be included would be some analysis around the consequences of a property price fall. Government with all its information can do this while individual firms cannot unless they pool some very sensitive data. Governments may want to share this data internationally or create a supranational agency. My guess is they would rather control it and share it than let an external body do it, but then it may create less personal risk for politicians to let an external body do it, so this decision will be interesting to monitor.

5. There will be critical evaluation and Government enquiries into why there was no anticipation of the storm, when data on property financing and CDOs was available from quite extensive reporting already. It will be less embarrassing for the incoming Obama administration in the US to demand such an enquiry than for the current UK administration which has been in power for 11 years. We all saw for years that America was living beyond its means on the back of rising property wealth, and buying more and more goods from China who then lent more and more money back to America and that this was not a sustainable position. But few individuals were able to see the scale of the bubble. The authorities could have, and should have shared it.

6. Far from becoming extinct, credit derivatives will eventually become widely publicly traded and quoted on exchanges. Why should it only be the financial elite who use this valuable market ?

7. There will be some re-evaluation of what the Authorities should share with the public and when. The natural inclination is to avoid creating instability as no-one wants to start a run on a bank, but in this case minor instability earlier would have been preferable. This issue is at the heart of the matter.

8. There will be a complete re-evaluation of the role of Rating Agencies. Should there be legislation to make clear that they have a duty of care to investors? Should they perhaps also revise the rating system to include not just present rating but some estimate of the sensitivity of rating to changes in market conditions. AAA-S1 meaning AAA and stable might be obviously less risky than AAA-V3 meaning AAA but very volatile.

9. Many hedge funds that rely on leverage will face a lethal combination of investor withdrawals and having to reduce their leverage. Many will close or merge - even good ones run by highly capable people.

10. Smaller banks and others like credit card companies will face a tough time and will have to redefine their business models to survive successfully. Many will merge and others will disappear.

11. The UK Government will become by far the biggest hedge fund in the UK with its stakes in several banks funded by massive issue of bonds. The Government will have a structurally huge incentive to try to keep interest rates low.

12. The overall effect on the UK could be massively negative. The City is by far the UK's most successful international industry and any significant weakening of the City by this crisis will be extremely serious for both the UK's foreign currency revenues and the UK Government's tax take from City firms, from high earners in the City who will earn less and from tens of thousands of people in the City who will lose heir jobs altogether. Expect an even weaker pound in the next year, and sharp UK tax rises after the next UK election. Let's hope that UK policy makers fully recognise the seriousness to the UK economy of a weakened City because acquiescence in a new world banking order of back to basics without financial innovation will hurt the UK greatly (and the New York tri-state area by the way) and benefit countries like Germany and Japan with a very strong industrial base. I suspect our policymakers do recognise it, but they will need to be very tough in withstanding pressure from other countries with less to lose.

What does this mean for Lombard Risk?

Positives are:

i) we are in absolutely the right areas of risk and regulation

ii) In the risk area banks want to spend despite cutbacks elsewhere. There is tremendous interest in collateral management at the moment. With COLLINE® we are the number 2 player in the world in collateral management software and are rapidly catching up the number 1. We have a good and growing pipeline for our collateral management software, and there is also pressure from regulators to handle counterparty risk and liquidity better.

iii) In the regulatory area we have a very large customer base of over 200 banks, and we see lots of pressure likely from regulators to deliver additional reporting functionality. Our customers will need this and we will be expecting them to pay for it.

Negatives are:

i) some of our customers will disappear and others will merge

ii) there will be more pressure to cancel non-essential projects - thankfully most of ours are essential

One of my biggest concerns at present is the lack of liquidity in the AIM market and the nervousness of investors generally. A company like us that is a market leader in various spaces and Global Number 2 in others needs access to capital at sensible valuations in order to be able to expand fast and pursue an M&A strategy. This is available in the Private Equity market. Yet the last two weeks have seen our share price fall by over 30% for no apparent reason but more to the point on only a few thousand pounds' worth of selling. This volume could easily have been mopped up by me or directors believing in the company but we are now in a close period due to our interim results and under AIM rules are unable to deal. One has to ask whether such rules really in practice serve to protect the interests of investors given that director dealings have to be disclosed anyway. But such is the way of all regulations - they can have unintended consequences.

This week sees Lombard Risk moving to its new much larger office in Shanghai and once again I find myself writing this blog in a plane over China.

Our new office in Shanghai has space for upto 150 people and will see us through several years of organic growth or growth by acquisition. We now house in Shanghai not only a development centre but also a quite sizeable implementation team to support projects all over Asia in conjunction wth our other offices in HK and Singapore.

A huge advantage of China for us is the ability very easily to deal with Asian character sets. China itself simplified its own character set about 20 years ago, but it is still an ideal base to support countries or regions whose character set is Chinese or based on Chinese. This includes Japan and Korea (where Chinese characters supplement Hiragana and Hangul) as well as Taiwan. It is so much easier to do this work in China than in the UK or even India, and it makes us an immediately credible company to support banks' regulatory compliance requirements in these countries.

We are now looking actively to increase our sales and marketing effort in China and are looking for outstanding candidates. With the presence we have there we believe we have significant revenue opportunities and that we can be a trusted and reliable partner for banks in China.

Business elsewhere continues largely unaffected by the credit crunch. Of course not every deal closes when expected and not every salesman meets sales targets, but that happens even in raging bull markets. Some of our customers are merging which brings opportunity for more revenue as well as a threat to existing revenue. But what we are not seeing is large scale deferral or cancellation of projects. This is not a commentary on the banking sector as a whole but is our experience in the risk management and regulatory compliance space.

On a lighter note I find that Lombard Risk is now in the GRC space. This is short for Governance, Risk Management and Compliance. Not an acronym I had heard of 18 months ago but one I suspect we will hear much more of like so many expressions that start life in the US. As my father (who is a university professor) once pointed out to me, language continually evolves.

The end of last week saw Lombard Risk announce a 25%+ increase in revenues over the previous year and a return to profitability in the second half of the last financial year, and it was obviously very pleasing to be able to announce this. Several times in the last year I have been told that private equity valuations for our type of company would be significantly higher than valuations on AIM, but I would so like to be able to prove this current received wisdom wrong – when the end game of any private equity investment is eventually to be able to achieve an IPO or trade sale, why on earth should a fast growing company like us that has started to become profitable and has already achieved an IPO trade at less than 1 times historic revenues when a lot of private equity valuations are in the range of 2-4 times revenues ? I continue to have faith that, assuming we continue to deliver results and growth, the AIM market will eventually value us in line with private equity valuations – it just makes no sense for this disparity to exist. But obviously valuation is for others to judge and the main way my team can influence it is to deliver results and spread the message that we are achieving results !

Once again, I believe strongly that my blog is a good place to share some of the personal views which trade partners and institutional investors expect to receive from me in private meetings, and which add further insights to the regulatory announcements we make or need to make from time to time. For obvious reasons it is harder to communicate 1:1 on this same level with most private investors, and as a result they otherwise would only have access to the regulatory information given to the London Stock Exchange (LSE), and would be disadvantaged versus institutional investors.

I have been asked several times what the current problems in the banking sector mean for our sector of the market and for Lombard Risk in particular. Time and time again I have found myself looking at the level of business we are achieving and then, after reading European and US newspapers which are so gloomy at present, wondering whether it is for real. But it is. I am not positioning myself as a commentator on the software industry as a whole, or on IT spending by the financial services sector, because there are several such expert writers in the UK and many others internationally, including some very capable analysts at investment firms, who do that for a living. But I can only share what my own experience is.

• Firstly, we are not experiencing any tangible slowdown in new business demand that I can measure. This is undoubtedly because we are in some of the right sectors -- regulatory compliance and risk management -- which banks either have to have, or need to have.

No banker that I know is enthusiastic about the ever growing level of regulation, yet I don’t know of a single one who thinks that the regulatory burden is going to decrease in the next 5 years – and we are the market leader in the UK and, globally, the number 2 provider in the niche market of bank regulatory reporting software.

• Secondly, the time is right for improved credit risk management and, through our COLLINE® software, we are a global market leader in proactive collateral management software, which is an integral part of credit risk management.

No Chief Risk Officer wants to go to his CEO to inform him that inadequate processes or software for collateral management have meant that his organization was among the last to call a counterparty on the brink of bankruptcy for margin. With what we believe is the best product in the market both functionally and technologically (e.g. fully web based end-to-end collateral management solution including repos and trade reconciliations) we are seeing a significant increase in interest in this area. As well as benefiting from the credit risk market opportunity, we also have been executing on a huge Y2K type program management operation requiring delivery of regulatory software upgrades for Basel and other regulatory changes to most of our UK customers. This exercise has resulted in quite a few changes in our processes and operations – more on this in later updates. We have also recently delivered the important COREP and FINREP regulatory reports working for Ireland and Luxembourg, giving us two new additional markets where we can compete very credibly. We are also making good headway in Asia where we will add several more countries later this year in which we will have an immediately deliverable solution.

We also are a provider of software for Anti-Money Laundering (AML) software, and more and more bank regulators are demanding that banks and investment firms have solutions for this. It was pleasing to see that we came 4th in a recent IBS Publishing global survey of new business gained for AML software in 2007.

The UK banking picture remains that we are seeing a continued deterioration in the market with property prices falling, greater negative equity, and higher delinquencies especially on buy to let mortgages. Quite apart from the Northern Rock debacle, the share prices of several UK banks and former building societies have fallen very sharply. More may be to come and I am told on very good authority that the property situation in Ireland and Spain is much worse than the UK. Falls in bank share prices and the repricing of the Bradford and Bingley rights issue have inevitably put great pressure on other firms in the sector which are assumed by the market to have similar problems and funding requirements. That restricts their funding which in turn restricts the availability of credit for buy to let which in turn can only lead to softer property prices and more negative equity. If unemployment were to rise appreciably at the same time as this and higher fuel and food prices, it would be very damaging for the personal spending outlook. So this game is not yet played out, but I do believe this outlook is now priced into most although probably not all UK bank share prices. I would personally be surprised to see any more UK bank failures – although not at all surprised to see the better capitalised banks acquiring the weaker banks in the mortgage market.

The big picture seems to me to be that we are seeing a major shift of wealth from West to East as the ownership of banks and other firms changes through continued recycling of the huge Far Eastern trade surpluses and of the Middle Eastern and Russian oil surpluses through Sovereign Wealth Funds and rich individuals into financial assets. It is a double gain for such entities that they can now pick up these shares at historically distressed prices.

Lombard Risk should be well placed in this fast changing picture. Firstly our focus areas of regulatory compliance and financial risk management are areas that banks either have to have or need to have. Secondly we are a global business; the current pessimism of the City of London and many other western financial centres is matched by the relative optimism of Asian financial centres as evidenced by the shortage of high quality office space in Singapore and Shanghai. Then specific to us we should be able to attack our cost/revenue ratio further as we build our regional presence in Asia and further improve our solution delivery capability. This combination of factors look set to help revenues and hold down our costs, which makes me cautiously optimistic.

Part of my motivation for writing this blog is that I believe passionately in allowing smaller investors similar access to my own and the company's thinking that institutions expect to get. I have written about this before, but it really is hard to see that small investors don't lose out on AIM. They get less information, fewer chances to talk to senior management and much less access to placings which are often done at below the market price. Aside from outstanding exceptions like t1ps.com and Shares Magazine, there is so little coverage of AIM stocks that small investors really do need to do a lot of their own research. I would stress that the views here are my own and not necessarily those of all of my board, but again that is what an institution would get in a one on one meeting!

Among the main strategic issues our company needs to have a view on at the moment are the following, in the context that Lombard Risk does business with about 200 banks and quite a number of asset managers or hedge funds:

I am struck by the disparity between the gloom and caution I hear from quite a few senior banker friends, and the fact that many of the traders who are mostly in their 20s or early 30s seem to believe this is no more than a short term correction. Perhaps it is simply because the latter have never seen a full scale recession and that they are as dismissive of the lessons of the past as any generation has been before them. Or they could be right and for every experienced risk manager in London or New York forecasting a downturn, there are Middle Eastern and Chinese investors waiting to snap up bargains and recycle some of the vast oil or manufacturing trade surpluses their countries are enjoying; a genuine new economy story in fact that few in work today have experienced before.

Where does this leave banks? The biggest effect of the U.S. sub-prime crisis followed by the incidents at Northern Rock, IKB, Landesbank Sachsen and so on seems to have been to dry up the interbank market (the lending by one bank to another). This is not because large banks have no liquidity, but rather that at a time when there are rumours about the solvency of individual banks no bank wants to be left having lent to that bank – there is little income from lending to other banks and certainly no prizes for getting it wrong. This in turn means that those banks that rely on net interbank funding are being much more cautious about doing business in case they can’t fund it. Presumably bank regulators are also making clear that this would be wise! Add to this the fact that the business a bank would previously not have taken onto its books but would have securitized or syndicated can no longer easily be laid off, and this further dries up borrowers’ access to funding and also pushes up the price of the lending margin a bank is going to charge. And to make it worse some of the loans that already had been securitized have had to go back onto banks’ books. So in summary I think that what this means for banks is the following:

Given the above issues for banks, it seems to me almost inevitable that banks will be looking, in as discreet a way as possible, to reduce their costs. Why discreet? Because in the current market, when every bank is questioning the credit worthiness of all its customers, no financial institution wants rumours going around that it itself is suffering from lack of liquidity. That will inevitably mean deferring non-priority expenditure or growth justified expenditure whether on recruitment, premises or technology. This will surely hurt rental levels and occupancy rates in the City, event organizers, those seeking large bank sponsorship, and anyone selling something a bank can do without for a little longer.

I look at this macro picture and it argues for a firm like Lombard Risk that supplies banks and asset managers/hedge funds to be lowering its revenue forecasts for calendar 2008 and cutting its own costs appreciably ahead of a likely downturn. But then I look at our own order book and find that we have had a record last three months for billings and that our key issue is managing implementation of multiple regulatory projects rather than any lack of new business. I attend our weekly management meeting, and find that our sales pipeline for 2008 is healthy and that new deals are there to be done. This argues for not cutting back.

Every CEO or business leader receives lots of advice, both internal and external, and has lots of data to look at. Inevitably not all of that data or advice points in the same direction, but it is still a CEO’s job to navigate through fog which will miraculously lift with the benefit of hindsight. The present situation for us where the macro picture is worrying while our own micro picture is encouraging is an unusual conflict in that data. But here is our thinking at present:

I am glad that unlike many technology firms our business model for 2008 doesn’t revolve around selling product or hardware upgrades for which banks see only marginal benefit, since that kind of expenditure will surely be at risk in 2008.

In summary I think that the business model we have at Lombard Risk should allow us to perform well in relation to other software companies selling to banks, and that we should almost be judged as a standalone company rather than as an IT company. Our current share price of just under 5p values us at below 1 x historic revenues, and well below 1 x analyst forecast revenues. Quite a number of software companies trade in the range of 2-3 x historic revenues. More than that I should probably not say!

I've been having quite a bit of interaction with fund managers recently thanks to our excellent Investor Relations professional Peter Gaze. Many small company CEOs lament the fact that their broker takes too little interest in their story, so perhaps the best way of ensuring one sees investors is to arrange it oneself. Companies don't expect a broker to arrange all their meetings with clients, so why on earth should that be the case with investors? As a company gets bigger, investors will be more inclined to find the company, but smaller firms have to do more of the work themselves.

What this always throws up is the huge disparity between what institutional investors learn about a business and what smaller private investors get to know. The securities laws are designed to protect smaller investors, but they also take away much of the ability a company has to treat its shareholders equally.

Here are a few examples :

I don’t know the solution to these issues, because everyone is acting in good faith and complying with the law, but the end result is that the private investor is systematically disadvantaged by the rules if he or she invests directly, and by management fees if he or she invests through a fund. My own favoured solution will be to find legal ways of reaching out to private investors to put them on a more level playing field with institutions but without costing the company huge extra expense and time. Anyone with good ideas on how to do this is welcome to e-mail me on

Time to get back to work. Our firm should be a major beneficiary this coming year from Basel 2 upgrades by all its regulatory reporting customers in the UK. And our information is that some of our competitors are behind with their Basel 2 products, so that gives us a good opportunity to gain market share!