Rogues of Wall Street. Waxman Andrew

applied routine customer facing banking skills to set up and self‐authorize fake bank and credit card accounts. It is apparent that investment banks, faced with increasing regulation in the investment banking sphere, have been turning to retail and private banking as alternative sources of revenue. Even Goldman Sachs has established a unit for online personal banking so it may be that this Wells Fargo incident is the first of a new emerging class of risk. It is clear at least that the regulations and procedures put in place by compliance and risk management were not adequate to address this risk at Wells Fargo.

      At the same time, it is also the case that banks have been able to put in place many sensible and effective controls to mitigate risks that they do run from their sheer size and complexity. Some of this has come about from the pressure that they have been put under by regulators. A friend of mine is an MD who works in an area called model risk at one of the major investment banks on Wall Street.15 Under the constant prodding of regulators and internal audit, he has constructed a complex set of controls over the various models used by the bank to value every single complex position that is traded there. If a trader is ever tempted to modify the way a position he is trading is valued, to perhaps help it reflect a profit to his greater advantage, it will be known straight away by those monitoring the valuation models. However, the separation of controls put in place most likely means that the trader, who in prior years would have been able to easily do such a thing, is now not able to do so. While this makes the bank safer than it was, there may be diminishing returns and unintended consequences from further nit picking by regulators with what has been accomplished.

      Added regulations and administration has meant the need for banks to add significant resources to meet these regulatory requirements while hamstringing them in other ways. The ban or severe restriction on proprietary trading, the Volcker Rule16 for example, arguably has already had some negative consequences, even though the ban has only recently come into effect. One unintended consequence is that as banks have been adding to the ranks of staff engaged in compliance matters while they have been losing and shedding the trading talent that has been the long‐term source of their competitive advantage. Traders and risk managers have been leaving to join hedge funds, asset managers, and even insurance companies in droves. This drain on talent, has only added to the difficulties banks face in managing their trading risks effectively.

      This is some of the context for the operational threats faced by the Banking and financial services industry today. Some of these are posed from the outside, some from the inside. What the banking industry cannot do is afford to let these threats subsist alongside their business model. Rather they have to address the issues head on. We will explore in the succeeding chapters how some of the changes described here have led to these threats and some of the tools that firms can leverage to address them successfully. We now turn our attention to some of these major events and losses.

CHAPTER 2

      The Rogue Trader

      The Rogue Trader is possibly the most famous in the Pantheon of Rogues of Wall Street. Over the years, there have been two types of Rogue trader: the one who blows up the firm in a sudden frenzy of wild trading activity and the one who acts with slow, steady accumulation of risk, unbeknownst to firm's management.

      Rochdale Securities, a once stable, small, firm in Connecticut, was taken out by a single trade in 2012 and so fits into the first category of a sudden burst of wild trading activity.17 Though the size of the loss was one of the smallest rogue trading episodes we have seen, $5 million in losses, its impact was devastating for Rochdale, which was subsequently forced to close. On the other hand, in 2011, UBS suffered far larger losses resulting from a Rogue Trader who slowly and steadily accumulated a huge level of risk, apparently unbeknownst to senior management. Like the Societe Generale episode before it,18 the Kweku Adeboli incident (see below) shook up the world of investment banks. “Could it happen here?” boards immediately wanted to know and they asked their chief executive officers. CEOs didn't know, so they, in turn, asked their chief risk officers. Their CROs didn't know so they asked their heads of operational risk. The heads didn't know so they asked their operational risk coverage officers. At that point, the question had probably already been answered in the negative back to the board so it probably didn't matter what the truth was. But the truth is, nobody knows where such an incident will happen again. The only thing that is known is that it will happen again somewhere.

      Who Is the Rogue Trader?

      So who exactly is the Rogue Trader, and what is the source of his roguishness? He is not the handsome rogue of your Victorian novel. Though he may be handsome, he probably won't want to attract undue attention to his activities. He is more likely to be the rat creeping around in your sewers, finding a home in the mess and dirt that never gets cleaned up. The profile of the Rogue Trader is fairly consistent: male, early thirties, not the most favored by birth or schooling. He likely has a strong sense of his abilities and is also likely to underestimate those of his better‐educated, more high‐born colleagues. More importantly, he is likely also to underestimate the risks of trading without active supervision. It certainly takes a good deal of self‐confidence to take on all the risks that the Rogue Trader takes on. Much of that self‐confidence is likely fueled by a bull market and a lack of experience and understanding of how markets can suddenly change to the negative. Like many traders, the Rogue Trader will tend to attribute his success to his brilliance rather than the market. Unlike other traders, however, he has no supervisors or colleagues to protect and help him when the market changes, because he does everything in secret.

      Generally, the Rogue Trader is not a direct entrant into the bank's trading team but came to it via a role in operations or the back office. Nor does he generally work in the most prestigious or complex areas of trading. More likely, he is part of a team that facilitates fairly routine types of trades for institutional clients. In the stand‐out cases such as Societe Generale, Barings,19 and UBS, the Rogue Trader has been distinguished by his operational knowhow and his aggressive approach. However, such attributes do not necessarily set him obviously apart from his colleagues. Moreover, such aggressiveness is likely to bring plaudits rather than suspicion from his manager. Kweku Adoboli, for example, was reported to have participated in sports betting on the side, and was evidently warned against such activity by compliance. Such activity could potentially have been a red flag. However, for those who have read Liars Poker20 and read about the card‐playing exploits of investment bank executives like James Cayne,21 such activity did not obviously stand out on the trading floor. In fact, it may be that supervisors would have seen this as an indication of the type of aggressive trading activity they were looking for in their young traders.

      Indeed, after working for two years as a trading analyst in the bank's back office, Adoboli was promoted to a Delta One trading desk. In 2008, he became a director on the ETF desk, and by 2010, he was promoted to director, with a total annual salary of almost £200,000 (about $254,000). Beginning in 2008, Adoboli started using the bank's money for unauthorized trades. He entered false information into UBS's computers to hide the risky trades he was making. He exceeded the bank's per‐employee daily trading limit of $100 million, and failed to hedge his trades against risk. In mid‐2011, UBS launched an internal investigation into Adoboli's trades. On September 14, 2011, Adoboli wrote an email to his manager admitting to booking false trades. His trades cost the bank $2 billion (£1.3 billion) and wiped off $4.5 billion (£2.7 billion) from its share price. The trading losses he incurred while trading for his bank were the largest unauthorized trading losses in British history.

      In other respects, Kweku Adoboli fitted the classic Rogue Trader profile to a tee. Being from Nigeria, he was clearly not from the classic Oxbridge, upper‐class English background favored by English investment banks. For his bachelor's degree, Adoboli went to Nottingham Polytechnic and studied computer science rather than Classics. He joined UBS in an operations role and was later able to cross over to a trading role on the Delta One Desk,22 where he facilitated large client equity trades.

15

In finance, model risk is the risk of loss resulting from using models to make decisions, initially and frequently in the context of valuing financial securities. Losses can stem from not having the key data inputs, incorrect calculations and algorithms, inappropriate calibration of the model, and so on.

16

The rule disallowing proprietary trading was credited to former chairman of the Federal Reserve Paul Volcker. In the light of the 2008 Financial Crisis, Mr. Volcker believed that one of the causes of the crisis was the ability of investment banks to deploy the capital of customers in pursuit of speculative and risky trades. The objective of the Volcker Rule then was to prevent such activity in the future.

17

Rochdale Securities was a brokerage firm that went bankrupt in 2012 due to a loss on a single trade that was executed. The failure came since the trade's losses were beyond the capacity of the firm to meet.

18

In 2009, Societe Generale lost over $7 billion due to the activities of trader Jerome Kerviel. This remains the largest‐ever loss resulting from a Rogue Trader. One of the tactics used by Kerviel to avoid detection was to create false counterparties that would then be used to authenticate his nefarious trades.

19

In many ways the original Rogue Trader, Nick Leeson managed to bring down the storied Barings Investment Bank all on his own. In the early 1990s, Leeson was able to take advantage of his role as head of operations and trading in a satellite trading unit in Hong Kong to take on huge, unhedged positions that resulted ultimately in a spectacular loss for the bank.

20

Liars Poker by Michael Lewis chronicled his adventures as a securities salesman at Salomon Brothers in the early 1980s. The title of the book comes from the poker game that was played on the trading floor. Trading heads were in many cases the instigators of the games, a sine qua non for success in trading.

21

James Cayne, known widely as Jimmy, was the CEO of Bear Stearns in the years leading up to the 2008 Financial Crisis. He gained some notoriety in the press for his publicized participation in bridge tournaments during some tough times for his company.

22

Delta One is the name for the trading desk on investment banking trading floors for some of the more straightforward equity trading activities. Delta One is so known because of the one‐to‐one relationship between the trades and swaps being executed on behalf of clients.