Category / Operational Risk and Rogue Trader

Fattening up the tails March 20, 2013 at 7:47 am

Many big banks have now had large operational risk-related events in the last few years, notably litigation related (think for instance of the PPI settlements in the UK or the mortgage ones in the US). What has that done to the banks’ operational risk capital models I wonder? You would have thought that having those large losses in the modeled distribution fattened out the tails no end…

Update Opdyke and Cavallo say:

…certain types of events are “industry” events that occur at multiple institutions in the same general time period, such as the wave of legal settlements related to allegations of mutual fund market timing. An institution that itself incurred one or more such losses may be justified in excluding other institutions’ losses (if they can be identified in the external data) since that specific industry event is already represented by an internal loss in the bank’s loss data base.

That is reasonable. What is less so is ignoring your own loss, taking the industry wide loss from some database and dividing it by the number of banks contributing towards the database. That has the effect of softening the loss considerably. Mind you, give what BofA for instance has paid out in mortgage related litigation, without that kind of approach its op risk capital requirement at 99.9% confidence under the AMA (were that to be the standard, which, right now, it isn’t in the US) would surely be more than the capital it has…

Planes not bridges December 10, 2011 at 7:30 am

If I had to pick an unconventional member for the financial stability board, I would seriously consider an aircraft safety expert. Let me explain.

Civil engineers know about one kind of safety; the safety of bridges and such like. The crucial thing about a bridge for our purposes is that the elements of it don’t change their nature when you change the design. They might change their role – whether then are in compression or tension say – but their physical properties are constant.

Two planes that kept us safe

Aircraft safety adds an element that civil engineers don’t have to worry about (much) – people. People react to the situation they find themselves in. They learn. Importantly, they form theories about how the world works and act upon them. Thus aircraft accidents are often as much about aircrew misunderstanding what the plane is telling them as about mechanical failure. The system being studied reacts to ‘safety’ enhancements because the system includes people, and hence those enhancements may introduce new, hard to spot error modes.

The report into the Air France 447 crash is an interesting example of this. See the (terrifying) account in Popular Mechanics here. As they say in their introduction to the AF447 Black Box recordings:

AF447 passed into clouds associated with a large system of thunderstorms, its speed sensors became iced over, and the autopilot disengaged. In the ensuing confusion, the pilots lost control of the airplane because they reacted incorrectly to the loss of instrumentation and then seemed unable to comprehend the nature of the problems they had caused. Neither weather nor malfunction doomed AF447, nor a complex chain of error, but a simple but persistent mistake on the part of one of the pilots

AF447 was, by the way, an Airbus 330, a plane packed to the ailerons with sophisticated safety systems. Not only didn’t they work, the plane crashed partly because of the way to pilots reacted to their presence.

Aircraft risk experts understand this kind of reflexive failure whereby what went wrong wasn’t the plane or the pilot but rather a damaging series of behaviors caused by the pilot’s incomplete understanding of what the plane was and wasn’t doing. This is often exactly the type of behaviour that leads to financial disasters. Think for instance of Corzine’s incomplete understanding of the risk of the MF Global repo position.

Another thing aircraft safety can teach us is the importance of an open, honest post mortem. Despite the embarrassment caused, black box recordings are widely available, at least for civil air disasters. (The military is less forthcoming, although things often leak out eventually – see for instance here for a fascinating account of the Vincennes disaster.) In contrast, we still don’t have FSA’s report on RBS, let alone a good account of what happened at, to pick a distressed bank more or less at random, Dexia. UBS is a beacon of clarity in an otherwise murky world.

It is hard to learn from mistakes if you don’t know many of the bad things that happened and what the people who did them believed at the time. Finance, like air safety, is epistemic: to understand it, you have to know something about what people believe to be true, as that will give some insight into how they will behave in a crisis.

The more I think about this, the more I think risk managers in other disciplines have to teach us financial risk folks.

My favourite operational risk loss of the week April 23, 2011 at 9:13 am

Detailed here:

An army of termites munched through 10 million rupees ($222,000) in currency notes stored in a steel chest at a bank, police in northern India said Friday.

Which Basel II operational risk loss category does that go in I wonder?

Operational risk in manufacturing March 16, 2011 at 4:10 pm

Basel 2 contains a substantial set of rules that require banks to monitor and capitalise operational risk. We screamed like scalded cats at the time, and I still think that the capital requirements are foolish, but one of the big advantages of making banks capitalise something is that they do actually start to monitor and manage it better. Thus banks are required to think about actual and potential vulnerabilities in their processes and systems.

Corporates typically do a much worse job of this, as the FT points out (HT Naked Capitalism):

Supply chains in many key manufacturing spheres increasingly hop across multiple borders. Last year, for example, the Asian Development Bank set about trying to assess how just one item, the iPhone, was made. This revealed a dazzlingly complex pattern, typical of numerous sectors. “Manufacturing iPhones involves nine companies, which are located in . . . the Republic of Korea, Japan, Taipei, China, Germany, and the US,” the ADB observed, adding that “the major producers and suppliers include Toshiba, Samsung, Infineon, Broadcom, Numonyx, Murata and Cirrus Logic”.

Now, in theory that dizzy patchwork of names and countries ought to imply that companies have plenty of choice about where to make things. In practice, however, competitive cost-cutting has forced companies to streamline their operations to such a degree that if something goes wrong with one step in their complex, cross-border supply chain, the entire system can break down.

In other words, complex supply chains might be cheaper, but they are also riskier. If you charge the capital needed to support that operational risk at a reasonable rate, then the cheap solution suddenly looks a lot worse. The practice of looking at risk adjusted returns outside of finance is in its infancy; it could be a powerful tool if its use grows.

Update. The famous example of over-vulnerable supply chains, of course, is Boeing. See here for a good analysis of how badly wrong the 787 project went thanks to tolerance of excessive operational risk in the supply chain. My personal favourite from the troubled history of this project is: ‘December 2007. Boeing CEO Scott Carson says there will be no further delays in the 787 program. Then in April, a 3-month delay is announced.’ Reputational risk is always close on the heels of this kind of operational risk.

CDO waterfall errors June 2, 2009 at 5:26 pm

CDOs are complicated. In particular, many of them have waterfall structures that include diversion tests – if x then tranche y gets some money, otherwise it goes to tranche z. Unsurprisingly, trustees sometimes get these tests wrong. Expected loss has found an example: I do encourage you to read it if you have an interest in either structured finance or operational risk.

Fear vs. Operational Risk February 4, 2008 at 3:38 pm

The FT reports that France’s Finance Minister Christine Lagarde wants bigger penalties for banks who are found to have weak controls in the wake of the l’affair Soc Gen:

France’s banking regulator must be allowed to impose far higher fines on banks that fail to monitor carefully the risks taken by their market traders, according to a government report on the rogue trading scandal that has rocked Société Générale.

I can see that there is a profound sense that something must be done, but I doubt raising fine levels will do much good. If the risk of losing a few billion euros is not enough to persuade the banks to invest in solid controls then it is hard to see that fines will do much good. The reality is that we have not had a big rogue trader event in a bank since Leeson and Iguchi in 1995 – John Rusnak does not really count – so some banks have become complacent. The most effective pressure would be disclosure, but I rather fear that the only result of having to disclose supervisor’s quality of controls scores would be to dilute their content.

As a side note, I wonder what effect the Soc Gen loss is having on industry operational risk loss databases. One would hope that it would be widening tail estimates and so capital would be going up.

Soc Gen offers 0% on balance transfers up to €50B January 30, 2008 at 8:38 am

Some interesting things concerning the Shock Gen event:

  • Margin. As Alea points out, the margin on Shock Gen’s positions would have been about 4.9B euro. Didn’t they notice they were funding a few billion euros more margin than they thought they were? If they thought the offsetting position was with a client, didn’t they call collateral from the client? Or were they in the habit of letting clients have billions of Euros of equity exposure without margin?
  • Unsurprisingly, shareholders are suing, claiming market manipulation.
  • Did Shock Gen find Kerviel or did Eurex? The FT raises the issue, then suggests Eurex first raised the alarm in November.
  • Kerviel did not lose 4.9B. He only lost 1.5B. OK, still chunky, but the other 3.4 came from management’s hasty closing of the position in a falling market.
  • Things not to say any time after Barings went bust: We all lived in fear that something within the exotic products would blow up in our face. It never came to our mind that we might have a problem with Delta One,” said a top Société Générale official.
  • Investigating judges in France have just thrown out the charge of attempted fraud against Kerviel.

And finally, I don’t usually quote extended passages, but this from the Daily Mash (from whom I borrowed the post title) is amusing enough to be worth reproducing:

FRIENDS of rogue trader Jérôme Kerviel last night blamed his $7 billion losses on unbearable levels of stress brought on by a punishing 30 hour week.

Kerviel was known to start work as early as nine in the morning and still be at his desk at five or even five-thirty, often with just an hour and a half for lunch.

One colleague said: “He was, how you say, une workaholique. I have a family and a mistress so I would leave the office at around 2pm at the latest, if I wasn’t on strike.

“But Jerome was tied to that desk. One day I came back to the office at 3pm because I had forgotten my stupid little hat, and there he was, fast asleep on the photocopier.

“At first I assumed he had been having sex with it, but then I remembered he’d been working for almost six hours.”

As the losses mounted, Kerviel tried to conceal his bad trades by covering them with an intense red wine sauce, later switching to delicate pastry horns. At one point he managed to dispose of dozens of transactions by hiding them inside vol-au-vent cases and staging a fake reception…

I’ll end with a few sea creatures you might find convenient if you have a few thousand equity index futures to conceal.

Soc Gen Shock January 25, 2008 at 8:31 am

Soc Gen has discovered there is less behind those nice sturdy vault doors than they thought. 4.9B Euros less, approximately, according to Bloomberg, thanks to the activities of a rogue trader, Jérôme Kerviel. They are raising 5.5B Euros of fresh capital.

The similarities with Barings border on the eerie. The trades were in equity index futures. They weren’t complex, nor did they involve options. Although the trader did not control the middle office, as Leeson did, he did have extensive knowledge of it from prior employment there, and hence managed to evade the firm’s controls. See here for the full statement.

Finally in a delicious irony, as FT alphaville points out, Soc Gen is Risk Magazine’s equity derivatives house of the year. (Recall that NatWest was high in Risk Magazine’s GBP and DEM interest rate derivatives league tables in 1994-996 just before they revealed their interest rate derivatives loss in, err, GBP and DEM.)

It is absolutely extraordinary that this can happen in 2008. To generate a five billion loss on asset backed securities is unfortunate. To do it on equity index futures is incredible. If the fictitious positions were exchange traded futures did they not do basic position reconciliation from the exchange to their systems? What about margin? If they were OTC forwards did they allow the trader to control confirmations from counterparties? What about collateral? The autopsy on this one will be interesting.

Meanwhile on Radio 4 this evening there has just been speculation that the dramatic falls in markets around the world earlier in the week were caused in part by Soc Gen liquidating its positions. If this is true and we got the 75 bps FED rate cut as a result, there is going to be some serious trouble. Surely Soc Gen couldn’t have dumped ten of billions of index futures without telling the regulators could they?

Update. The Bank of France knew but neither they nor Soc Gen told the FED according to Bloomberg. That’s shocking.

The Guardian is uneqivocal here: ‘SocGen’s desperate race to clear up the damage and unravel Kerviel’s trading positions were at the heart of the stockmarket turmoil on Monday when share prices across Europe crumbled by 7%.’ We won’t know if that is really true for a while, but for now I’ll leave you with a link to a summary of the Market Abuse Directive. Note in particular

Market manipulation comprises three parts. These are: transactions and orders to trade that give false or misleading signals or secure the price of a financial instrument at an artificial level. [...]

Update. There is a nice New York Times article on Soc Gen’s unwind, Société Générale’s Sales May Have Incited Market Plunge, with details of the notionals transacted on Monday and Tuesday here. They going to be in serious trouble with the FED if these suspicions turn out to be true.

What does safe mean? May 25, 2007 at 9:43 pm

It is an interesting question. Nothing is safe, 100% robust under any set of circumstances. If a two hundred foot high sea monster climbs out of the Thames and starts munching on Canary Wharf a few disaster recovery plans would doubtless be found wanting.

There are at least two issues. The first is to encourage people to be skeptical about the performance of any construction, mechanical, electronic or intellectual: there are some events that will screw up any design.

But then we come to the problem of how to estimate how unlikely these testing circumstances are. Typical operational risk events involve a concatenation of errors, of individually improbable circumstances. Sadly it seems that sometimes these events are not independent so that the joint probability of a screw up is much bigger than one might think. For that matter, the equity, credit, FX and interest rate markets often have low return correlations: but they can all move together in a crisis, as LTCM found out. It isn’t that a plausible worst case is bad — we knew that — it is that the worst case can be much more likely than it appears.