Transcript – Combating Rogue Trading No Surprises Geoff Kates Managing Director Lepus

No Surprises – Combating Rogue Trading
Geoff Kates
Managing Director Lepus
www.lepus.co.uk
Overview

Introduction

Gallery of Rogue Traders

Why does it still happen?

Why have lessons still not be learnt?

What should be done?
www.lepus.co.uk
Gallery of Rogue Traders

Drexel Burnham Lambert – $650M - 1990

Allied Lyons – £150M - 1991

Bombay Stock Exchange - $1.3B – 1992
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Metalgesellschaft - $2.2B rescue – 1993
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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
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Griffin - $10M – 1998
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Chase Manhattan - $60M – 1999

Transcanada Pipeline - $49M – 2000

Muirpace - £32M – 2000

AIB - $750M - 2002
www.lepus.co.uk
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
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Senior Managers covering up their juniors
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Agency Problem

Traders do not have the concept of ownership
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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
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Listen to regulators
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Protect against insolvency
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Outsourcing of Trading
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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?
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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?
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Supervisory
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Trades against confirmations
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Credit and Trading Limit
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Cash Flow
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Anti-Collusion
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Counterparty

Cash Trades vs. paper gains
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Supervisory Controls

All Trading Supervisors should have separate clearing and
operational duties
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Separating Front from Back Office
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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
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Risk Managers should be notified on discrepancies

Cannot cut corners on this
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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
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Issued and monitored with due attention

Watch for (excessive) breaches of these limits
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Match the P&L with the credit limits of every trader
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Cash Flow control
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Ultimate test of whether rogue trades are taking place
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Much harder to conceal cash that has to be paid to a
counterparty
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Look for unusual cash requests from traders
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May not be a good measure some of the time due to
volume of individual trading
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Anti-Collusion Controls
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Various measures have been tried
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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
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Counterparties often see evidence of rogue trading before
the banks with the problems do
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Many examples of this
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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?
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If it looks too good to be true it probably is
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No trader makes money 100% of the time
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“Check your profits as closely as your losses”
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Detailed checks of Balance Sheets
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How often should the checks be carried out?
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Small banks – batch based overnight
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Larger banks – intra-day
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Ideal – deal by deal
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Who should supervise and carry out checks?
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Supervisors
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Risk Managers
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Traders
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Counterparties
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Internal Auditors
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External Auditors
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Supervisors
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Need to have long and relevant experience
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Understand the peculiarities of the front office
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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
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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
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Traders not making money if other traders breaking rules
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Longer Term view should be that if a rogue trader exists,
will affect the bonuses of them all
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Joint responsibility/scorecard approach may be way
forward
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Counterparties
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Part of their role should be responsibilities over their peers
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Often the first to recognise a rogue trader
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Consistent betting against a trend
Volumes rise dramatically
Need to inform more the rest of the banking community
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Internal Auditors
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Need to co-ordinate closely with Risk Managers to spot
inconsistencies
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Need to raise level of expertise to spot what is happening
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External Auditors
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Proved to be the weakest link in the chain of controls
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Fail to carry out comprehensive audits due to lack of
specialised knowledge
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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
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Technology being used more to support supervision
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Tools such as Autonomy and Searchspace starting to be
used
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4. Consider Holistic Risk Management Approach
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Risk and Finance Managers need to work with each other
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The ‘REAL’ approach (Risk Enterprise and Accounting
Logic)
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Based on Accounting consistent with Economic Evaluation
of Business
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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
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Contracts need to be completed and put in place quickly
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Hard to spot rogue ‘complex’ trades otherwise
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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
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Bonus related to performance of bank (by issuing shares as
bonus)
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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
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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
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Seen as assisting, not as adversary
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Good at spotting and disseminating best practices
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Used as a resource and sounding board
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8. Protect yourself against Insolvency
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Operational Risk Capital Allocation
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Rogue Trader Insurance
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Operational Risk Capital Allocation
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Big controversy about this area
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How effective is it
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Lot of debate
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Some banks already allocating capital against business
units based upon results of internal audit
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Rogue Trader Insurance
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Number of players in this market
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SVB – 30 Banks have taken out their Insurance
Swiss Re – broader coverage, higher minimum loss
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9. Outsourcing
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Isolation of proprietary trading areas
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‘Internal Hedge Funds’
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Limit legally the capital exposure
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Reaction to concerns of rating agencies
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10. Psychology
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Need to understand the psychology of traders
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Look at 3 areas
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Disposition
Learning Experiences
Trading Environment
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Conclusions

Never become complacent about internal controls

Continuously reassess and improve Risk Management
Systems
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Look closely at the 10 areas detailed above

“If it looks too good to be true it probably is”
www.lepus.co.uk