Rogues of Wall Street. Waxman Andrew

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      Andrew B. Waxman

      Rogues of Wall Street

Rogues of Wall StreetHow to Manage Risk in the Cognitive EraAndrew B. Waxman

      Copyright © 2017 by International Business Machines Corporation (“IBM”). All rights reserved.

      Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

      Published simultaneously in Canada.

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       Library of Congress Cataloging-in-Publication Data is available

      ISBN 9781119380146 (Hardcover)

      ISBN 9781119380177 (ePDF)

      ISBN 9781119380153 (ePub)

      Cover Design: Wiley

      Cover Image: © Photo by.Ignacio Ayestaran/Getty Images

To my mother and father of blessed memory, Anthony and Lynda Waxman, who inspired in me a lifelong love of good writing and analytical thinking

      Introduction: A Risky Business

      The managing director for risk fixed him with skeptical blue eyes, “you are probably the most dangerous person at this Bank”. I was incredulous. She wasn’t talking to a swaggering trader. She was talking to her supposedly close colleague, the Head of the Global Policy Office at the Bank. The discussion for the last hour had been about the need to strengthen global compliance policies for Sales and Trading in the aftermath of the 2008 Financial Crisis. Surely, I thought, the danger must lie elsewhere.

      Why do I open with this story? In many ways it’s symptomatic of what was wrong at banks before and after the 2008 Financial Crisis. There were traders losing money hand over fist, in some cases, to the point of taking their banks over the edge during The Crisis, yet the MD perceived the greater threat as stemming from the Global Policy Office. Really? The pre-Crisis view was that traders should be left more or less alone by Risk and Compliance to work their magic. This did not work out so well in retrospect. After The Crisis a new belief took hold, almost as pervasive and erroneous as the “let traders be traders” view. The new belief was that rigorous enforcement of new policies and procedures would lead almost magically to prevention of wrongdoing. The MD, perfectly cognizant of this, was afraid that risk managers would retreat behind a bureaucrat’s desk rather than engaging with day-to-day activity on the trading floor and that the effects would be just as bad as previously. Sadly, in her defense, to a significant extent it’s my view that this is what has gone wrong after the crisis.

      The evidence presented in this book suggests that both these factors have been at play in the years since the Financial Crisis. The strengthened regulatory and compliance regime imposed since the 2008 Financial Crisis this has not yet resulted in a corresponding reduction in operational risk events and failures.1 Even a cursory reading of newspaper headlines in 2016 provides sufficient evidence of that point: Ponzi schemes, fictitious bank accounts, and cybersecurity failures are still common occurrences. The book’s objective is, however, not to offer a critique of these rules and regulations or to argue that they are not needed.2 The main objective of this book, rather, is to hold up a mirror to events caused by the Rogues of Wall Street – to analyze and understand them and then describe ways and techniques for identifying, mitigating, or preventing them in the future.

      This past decade has been an exceedingly turbulent one for banks and the financial services industry. So many losses have been paid out to investors, regulators, and clients as either straightforward financial losses or penalties paid out for accepted wrongdoing. The trade date for many of these losses was the financial crisis of 2007–2008. Settlement date was often later – in some cases, as late as 2016 – before the penalty was paid. Even in 2017, regulators are still announcing the settlement of cases with banks that go back to 2007 to 2008.3

      I worked in operations and risk management at several large banks in the 2000’s. As such, I participated in what are called “scenario planning workshops.” The goal of these workshops was (and is) to estimate the size of potential losses in the worst of circumstances, black swan type events. I have to admit, however, that during these discussions, we hardly conceived of losses at the levels they have since reached. With multi-billion penalties incurred in some cases, it is now evident that banks failed to price these types of risks properly.

      It is also apparent that financial crises hold special trepidation for banks and other financial institutions. This is largely because unknown operational risks4 that, banks and other financial institutions hold on their books, are suddenly and ruthlessly exposed at such times. In 2008, bank losses suddenly ballooned from areas as disparate as credit default swaps, debt offerings, mortgage securities, money market funds, Ponzi schemes (Madoff), rogue trading, hedge fund positions and so on. Some institutions were pushed over the edge – Bear Stearns, Lehman Brothers for instance – while many others barely survived. This was no coincidence. Rogue trading positions, Ponzi schemes, even losses on mortgage securities, can be smoothed over, hidden by high profits, during the good times, but not during the bad times. Madoff’s scheme, for instance, finally came to light in December 2008 after years of successful concealment. Driven by sudden cash needs, brought on by the Financial Crisis, multiple investors asked for their money at the same time. The demand for cash could not be met by Madoff’s cash on hand and the harsh reality was suddenly exposed. This same dynamic played out across multiple venues, markets and

2

A key scandal was unearthed in 2016 involving Wells Fargo and retail bank customers. This seems to be something new. A Ponzi scheme was also uncovered at Platinum Partners. This was something old. http://www.nydailynews.com/new-york/nyc-crime/platinum-partners-hedge-fund-bigs-face-charges-1b-fraud-case-article-1.2916343.

3

US Department of Justice, “Deutsche Bank Agrees to pay $7.2 Billion for Misleading Investors in Its Sale of Residential Mortgage-Backed Securities. Deutsche Bank’s Conduct Contributed to the 2008 Financial Crisis” (January 17, 2017), https://www.justice.gov/opa/pr/deutsche-bank-agrees-pay-72-billion-misleading-investors-its-sale-residential-mortgage-backed.

4

Operational risk is the risk that deficiencies in information systems or internal processes, human errors, management failures, or disruptions from external events will result in the reduction, deterioration, or breakdown of services provided by an FMI. http://www.bis.org/cpmi/publ/d00b.htm?&selection=48&scope=CPMI&c=a&base=term.