A few weeks ago the world heard of yet another rogue trader at
UBS, with the bank picking up the tab to some $2.3bn, estimated loss, but this could rise as more details emerge. This is
just another rogue trader story, on the back of the many others, from Nick Leeson at Barings Bank through to todays UBS, but
believe me there were more before Leeson. What is plain to me is that rogue traders are a fact of life in financial markets
and no amount of rules, risk systems or controls will be enough to prevent the next one and the next one after that and so
on. With this in mind a fresh look is required at why and how these instances of fraud materialise and to find new methods
to minimise the number rogue traders and limit the damage they cause.
There
is a déjà vu in the aftermath of every rogue trader story and today the UBS fraud is showing signs that mimic
the past. The following weeks and months will see the finance industry, including the regulators, banks, politicians and police
all move into high gear, deploring the fraud and insisting on new controls and new systems and with a heightened desire to
prevent reoccurrence. These will all fail! We know this because it happens so frequently and this reaction follows each horror
story almost as instantly as it breaks.
Over the years untold amounts of
money and time have been spent on systems and structures by banks and the market for the sole purpose of prevention but as
we can see nothing has worked and indeed the losses are getting higher and the frequency more. Perhaps it's worth trying
a new tack!
The culture of markets is to take risks as it is through volatility
and risk taking that banks make money. Inert markets stagnate and make no one any money, so risk taking is encouraged and
for the main part welcomed. However we all know to our cost that Banks have been the worst risk takers imaginable where decision
making is often wrong and because of the size of their risk capital can move markets and prices violently causing volatility
and losses to smaller investors. At worst the banks can manipulate markets with the strategic playing of situations that suit
their own book. This is the Casino mentality that the media and politicians have promoted. However, all this is a relatively
new phenomenon as for most of the banks history going back centuries they have been risk averse. This really changed 25 years
ago in the UK with ‘Big Bang' which replaced a single capacity market with duel capacity. Big Bang in the UK was
such a success that it became the forerunner of the structure of other international markets and in particular in the USA
with the repeal of the Glass-Steagall Act.
In the UK prior to ‘Big
Bang' the risk takers were the ‘jobbers' (market makers) who risked their own capital by making a market with
brokers who could only invest their clients' money and earn commission as a result. Jobbers could not deal for clients
and brokers could not invest their own capital for their own gain.
Clearly
this prevented investors' money being used to fund the risk taking by Jobbers and forced the management of jobbing positions
to be closely monitored. Extended positions and especially naked shorts were watched with some anxiety by the jobbers'
owners and undue risks were not undertaken without authority. This is the model we are all trying to get back to today, through
rules and regulations and artificial market capital structures, installed via Basel One, two and now three, to control the
amount of funds banks pile into the stock markets
After ‘Big Bang'
the banks purchased old family firms of jobbers and brokers and put them under one roof along with their asset management
business and the overall capital of the bank creating significantly new large sums to put into the market. Banks no longer
looked to invest in safe market products with a sensible annual return as now there was the possibility of gaining massive
returns based on utilizing the bulk of the assets under the banks control. Now it was a case of keeping up with the Joneses,
with banks anxious to ensure they were bigger and better than their competitors. Throughout the eighties and nineties banks
bought other banks or merged to create bigger banks, with vast sums of money under their control to invest in even greater
numbers, and importantly in more diverse global markets, and through new complex strategies.
So the banks ability to run positions and take risks became an explosive opportunity to make huge amounts of money
on an almost exponential scale. Larger and larger positions were taken and this just kept increasing the profits as the industry
enjoyed a huge and extended bull market, that is, until 1987 and the market crash and global correction of prices. Before
then, they could hardly fail, after the crash, the cold water shower of bear market realism said ‘we can fail'.
The 1987 crash was an extremely important event in shaping today's market. Banks in 1987
were given a complete shock and reality check on what can happen in stock markets. This resulted in a drive to ensure positions
were hedged and naked shorts were more closely managed. It also created the ‘Group of Thirty' a combined global
work group that established that markets had to make key changes in post-trade operations to enable shorter settlement cycles
and closer intraday management of securities and treasury positions. In the UK this created the Electronic Trade Confirmation
(ETC) and the use of SWIFT in the securities market, eventually 3 day rolling settlement and the closing of the gap between
settlement operations and treasury. All very good developments that were designed to drive down costs and operational risks
that at the time were seen as the most damaging. However, the emerging threats beginning to gestate in the front office would
soon swing emphasis towards market risk and all the other risks associated with global trading.
In the front office it was found almost by accident that pcs enabled spreadsheets to be created
that could produce information on local markets and global risks that helped the head of the dealing desk and the board to
understand something of the day-to-day risks they were undertaking. Banks with global branches had often struggled to maintain
day-to-day controls centrally rather preferring to sanction limits to each branch and local management responsibility. In
those days the markets had not quite achieved the level of integration and influence of today and these systems were thought
adequate. But, the latency in the compilation of the data from all branches and even from a domestic central bank aspect was
a limiting feature, reducing its value to the board to little more than just interesting. The reason was that by the time
information was entered on the spreadsheet it was already out-of-date and defunct information was not much use if the bank
wanted to proactively manage its positions. However, it was the beginning of the banks understanding the risks that
they were taking and had begun the thought process and eventually the desire, for intraday risk management.
In no time the greater appreciation and knowledge of market risks led directly to the creation
of OTCs and banks sold this capability to large investors. In the beginning the OTC market was small and fragmented but the
realisation of what could be achieved with OTC sporned new OTC products and a massive new opportunity to make even more money.
For banks it looked like money for old rope as it had minimal impact on the balance sheet but created huge exposures into
markets and products that they thought secure. Hedging was performed when demanded but silver tongue traders could often pursude
the boards indulgence with seductive messages of profit and increased dividends.
As the profits ballooned banks were more than happy to throw more money at the business. After all, every idea so
far had worked and even if the odd bomb was dropped losing 10 or 20 million dollars, the number of 100 million dollar profitable
deals, more than compensated. New ideas to create more new financial products and enter more global markets began the path
towards globalisation that was released once the Internet became a key part of everyone's lives.
OTC and the use of ever more intelligent computers attracted a new breed of trader. Gone was the jobber who although
not always loved would always be mindful of the need to maintain their business bloodline relationship with the broker. The
Jobber was replaced by the computer geeks. These guys just saw the market as a mathematical equation and got hot with the
thought of greater speed and capacity to trade huge numbers of transactions. Global arbitrage between markets was now easily
undertaken and the overlapping connections between different global markets were established.
During this time as the capability of the banks increased and profits continued to spiral their boards began to lose
any understanding they once had about their business. Pre Big Bang any board member would know exactly the business they were
in and how the business operated. The trend was set by banks introducing a middle layer of managers to manage the business
on their behalf and so compliance officers and risk managers began to take a much higher profile in the business. Unfortunately
the more expertise that was brought in and the more they were paid, the further removed the board became from the business.
Sure responsibility was always at board level but in reality the middle managers were actually running the business. Short
termism of employment then became a feature of the industry. Managers who would once have a complete career with a bank began
moving with ever increasing frequency and for more money each time. This fact alone broke the unwritten contract of loyalty
and caused managers to become more laissez-faire about the risks they were prepared to allow, if it made the bank more money
and they in turn gained greater rewards in salary and bonuses.
Now bonuses
have always been a feature of the City but were managed historically in a completely different way. For example if a Jobber
or Broker had a great year, all staff were given a bonus however, basic salaries were relatively modest. The firm's owners
obviously took the lions share but that was fine, as they were investing their own money and taking the business risks. If
the year was bad so was the bonus or there may not be a bonus. Everyone accepted the fact and everyone was in the same boat.
Unlike today were bonuses are written into contracts and form a major part of an employee's remuneration whatever their
or the banks performance.
As employees became less loyal to the bank and
more self-promoting, an environment was created where risks were more a case of heads the bank loses and tails the employee
wins. For the banks it became more about performance. If the employee was making huge profits for the bank, keeping its shareholders
happy with ever increasing dividends and increased share capital it was happy. No one questioned why they were making so much
money. Reading the Nick Leeson story and having discussed his case in detail I am left certain that the Barings managers were
as culpable as he was in the fraud. Ignorance has never been a defence but at Barings it seems to have been the case.
Leeson was able to get away with his fraud because he understood the back office and the culture
of the bank and the managers who were prepared to not look too closely or ask questions about the profits. This is a scenario
that appears to be common to this type of fraud.
It is the culture of the
banks that appears to be the common denominator. In that when the bank employs people that have a personal motivation and
desire to make huge profits they also appear to be given carte blanche, to the keys of the vault.
Loyalty has to be a two way street and the banks can be blamed for not showing enough loyalty to their staff in the
past. Sacking people in order to follow the market down and then paying massively to reemploy staff, as the market booms tends
to encourage disloyalty and disloyalty is a breeding ground for fraud. When the risks of fraud are less than the rewards of
the act, the result is inevitable.
Another common feature of massive fraud
is the knowledge of people in the front office of the back office operations and systems. There is a strong case for not promoting
people from the back office into the front as they are armed with too much knowledge and if tempted could carry out fraudulent
activities.
It's also interesting that a number of frauds are not for
personal direct financial gain but to cover up errors either by the perpetrator or their colleagues, ironically out of misguided
loyalty or fear. The banks are to blame for creating a culture where errors are covered up rather than brought to management
attention for resolution.
Everyone makes errors but if employees are so
scared of the ramifications that they will risk fraud rather than owning up, then the bank has to look closely at its internal
culture and the people they employ to manage the business.
In summary the
cultures of the pre big bang market and today's market are in stark contrast. The banks have created a market culture
of disloyalty and fear where the fraudulent perpetrators are scared of raising errors for resolution.
- The banks remuneration and bonus culture adds pressure on employees to protect their position
rather than the banks.
- Risk systems and rules are worthless unless the
culture of the bank is such that it encourages loyalty and its board has greater understanding of the banks business and operations
so it can interact with its managers.
- Bonuses and remunerations have
to be proportionate to the activity of the employee and the profits of the bank and seen to be fair across the industry. Banks
should also instil a mutually acceptable hierarchical culture of reward for loyalty.
- Promotion between front and back office must be carefully considered, concerning the possibility of fraud and in
such cases ring-fencing of system access has to be enforced and communications between people in different operational areas
has to be recorded.
It's time to extend the reaction to fraud
to not just systems and rules, but to culture and to understanding how this can create an environment where fraud is a likely
scenario.
