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No Surprises – Combating Rogue Trading

Geoff Kates

Managing Director Lepus

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Overview

Introduction Gallery of Rogue Traders Why does it still happen? Why have lessons still not be learnt? What should be done?

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Gallery of Rogue Traders

Drexel Burnham Lambert – $650M - 1990 Allied Lyons – £150M - 1991 Bombay Stock Exchange - $1.3B – 1992 Metalgesellschaft - $2.2B rescue – 1993 Chile Copper Group - $175M – 1994 Barings Bank - $1.3B – 1995 Daiwa - $1.1B – 1995 NatWest - £90.5M – 1995 Common Fund of the United States - $128M – 1995

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Gallery of Rogue Traders

Sumitomo - $1.8B – 1996 Deutsche Morgan Grenfell - £400M – 1996 Credit Suisse - $10M – 1997 Griffin - $10M – 1998 Chase Manhattan - $60M – 1999 Transcanada Pipeline - $49M – 2000 Muirpace - £32M – 2000 AIB - $750M - 2002

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Why does this still happen?

Increased Complexity of Financial Firms & Traded Instruments

Insufficient risk management and internal controls Inefficient risk management and internal controls Collusion Agency Problem

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Increased Complexity

Global Institutions High Volume, many counterparties Complex chain of events Exotic Products

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Insufficient Risk Management & Internal Controls

Pressures of Cost Efficiency Insufficient controls for remote offices Bureaucratic rather than genuine controls

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Inefficient Risk Management & Internal Controls

Not enough Collaboration between parties involved Not many banks have one individual for Operational Risk Information is not integrated

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Collusion

Front and Back Office working together Senior Managers covering up their juniors

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Agency Problem

Traders do not have the concept of ownership Accountability Hedge Funds have clear ownership

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Why have lessons not been learnt?

Lessons have been learnt but to a different extent Lessons have been learnt but loopholes still appear

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Lessons have been learnt but to a different extent

Large banks have been spending money on it Larger budgets More sophisticated Risk Management Systems Tighter internal controls

Problem in smaller banks is lack of resources

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Lessons have been learnt but loopholes still appear

Changes have occurred Better Capitalisation Segregation of Front and Back Office

Complexity of controls make them easier to overcome

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Could regulators have done more?

Introduce minimum risk management standards for all banks

Ensure integrity of the system Reduce high leverage of some 1st Tier Investment Banks

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What should be done?

Reassign Responsibilities Improve basic risk management standards Reassess Internal Controls Holistic Risk Management Approach Escalate Processes Reassess remuneration policies Listen to regulators Protect against insolvency Outsourcing of Trading Psychology

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1. Reassign Responsibilities

• Shared amongst all parties involved• Supervisors• Traders

• Proactively driven from the top• All levels of employees should be empowered to prevent

Fraud• Clear lines of responsibility and accountability should be

established• Senior management should be role models for all

employees

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2. Improve basic risk management standards

• Unresolved Issue for smaller (overseas) branches• Head Office quite often does not fully understand what

overseas branches are doing• Risk still seen as extra expense of doing business• Information flow key to doing business• View moving to seeing Risk Management as a revenue

enhancing tool

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3. Reassess Internal Controls

Checks and Controls that should be in place How Meticulous should checks be? How often should the checks be carried out? Who should supervise and carry out the checks? What are the supervisory tools?

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What Checks and Controls should be in place?

Supervisory Trades against confirmations Credit and Trading Limit Cash Flow Anti-Collusion Counterparty Cash Trades vs. paper gains

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Supervisory Controls

All Trading Supervisors should have separate clearing and operational duties

Separating Front from Back Office Trading sheets should be checked and signed off daily

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Checks of Trades against Confirmations

Checks of individual trades against counterparty confirmations is essential

Risk Managers should be notified on discrepancies Cannot cut corners on this How to check – ask a trader how many unresolved

confirmations they have each day and how old the latest confirmation is.

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Credit and Trading Limit Controls

Issued and monitored with due attention Watch for (excessive) breaches of these limits Match the P&L with the credit limits of every trader

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Cash Flow control

Ultimate test of whether rogue trades are taking place Much harder to conceal cash that has to be paid to a

counterparty Look for unusual cash requests from traders May not be a good measure some of the time due to

volume of individual trading

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Anti-Collusion Controls

Various measures have been tried Traditional Whistleblowers Supervisor scorecards Independent supervisors reporting to the board Operational, Financial, Risk and Legal all have representation on

the board

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Counterparty Controls

Counterparties often see evidence of rogue trading before the banks with the problems do

Many examples of this Barings (whole market) AIB (Goldman Sachs)

Encourage a culture of communicating this

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Checking cash trades offset with paper gains

Reconciliation of such areas is crucial to spotting rogue trading

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How meticulous should the checks be?

If it looks too good to be true it probably is No trader makes money 100% of the time “Check your profits as closely as your losses” Detailed checks of Balance Sheets

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How often should the checks be carried out?

Small banks – batch based overnight Larger banks – intra-day Ideal – deal by deal

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Who should supervise and carry out checks?

Supervisors Risk Managers Traders Counterparties Internal Auditors External Auditors

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Supervisors

Need to have long and relevant experience Understand the peculiarities of the front office Should have a multi-layered hierarchy of Supervisors

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Risk Managers

Number of banks feel they should be on the floor in direct contact with traders

Should not interfere with traders if within prescribed limits Should concentrate on where limits have been broken and

how supervisors allowed this

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Traders

Traders not making money if other traders breaking rules Longer Term view should be that if a rogue trader exists,

will affect the bonuses of them all Joint responsibility/scorecard approach may be way

forward

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Counterparties

Part of their role should be responsibilities over their peers Often the first to recognise a rogue trader

Consistent betting against a trend Volumes rise dramatically

Need to inform more the rest of the banking community

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Internal Auditors

Need to co-ordinate closely with Risk Managers to spot inconsistencies

Need to raise level of expertise to spot what is happening

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External Auditors

Proved to be the weakest link in the chain of controls Fail to carry out comprehensive audits due to lack of

specialised knowledge Need to raise standards of performance

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What are the supervisory tools?

Best tool is fully qualified staff with extensive experience and knowledge

Technology being used more to support supervision Tools such as Autonomy and Searchspace starting to be

used

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4. Consider Holistic Risk Management Approach

Risk and Finance Managers need to work with each other The ‘REAL’ approach (Risk Enterprise and Accounting

Logic) Based on Accounting consistent with Economic Evaluation

of Business Needs to be a ‘Power’ Relationship with discrepancies

being investigated

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5. Escalate Processes

All procedures in Front, Middle and Back Offices need to be managed efficiently

Contracts need to be completed and put in place quickly Hard to spot rogue ‘complex’ trades otherwise Need to escalate and make sure processes are consistent

and efficient

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6. Reassess remuneration policies

Large Part of Traders performance related bonus needs to be deferred

Bonus related to performance of bank (by issuing shares as bonus)

Look at how much traders make over a period of time rather than just a single year

Reduce discrepancy of trading and non trading compensation

Make sure risk and back office staff are paid the right amount to get the right quality of people

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7. Listen to Regulators

Seen as assisting, not as adversary Good at spotting and disseminating best practices Used as a resource and sounding board

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8. Protect yourself against Insolvency

Operational Risk Capital Allocation Rogue Trader Insurance

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Operational Risk Capital Allocation

Big controversy about this area How effective is it Lot of debate Some banks already allocating capital against business

units based upon results of internal audit

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Rogue Trader Insurance

Number of players in this market SVB – 30 Banks have taken out their Insurance Swiss Re – broader coverage, higher minimum loss

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9. Outsourcing

Isolation of proprietary trading areas ‘Internal Hedge Funds’ Limit legally the capital exposure Reaction to concerns of rating agencies

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10. Psychology

Need to understand the psychology of traders Look at 3 areas

Disposition Learning Experiences Trading Environment

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Conclusions

Never become complacent about internal controls Continuously reassess and improve Risk Management

Systems Look closely at the 10 areas detailed above “If it looks too good to be true it probably is”