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Case studies – Sumitomo

  • Yasuo Hamanaka – copper trader at Sumitomo manipulated copper prices on London
  • Metal Exchange
  • Fall in copper prices in June 1996 after revelation of Hamanaka’s unfair dealings led to ~US$2.6 Bn loss for Sumitomo
  • Positions were so large that company could not liquidate them completely
  • Hamanaka used his independence to trade in the market on behalf of the company and manipulated the copper prices by buying physical copper in large quantities and storing in the warehouse thereby creating lack of copper in the market
  • He sold put options to collect the premiums as he thought he can push the prices up and thus writing put options was not risky for him
  • Though, he never imagined that he could be susceptible to steep decline of copper prices
  • It had various risk exposures ….such as Operational Risk, Employee / People Risk, Liquidity Funding Risk, Market Risk

Case studies – LTCM

  • LTCM was a hedge fund using highly leveraged arbitrage trading activities in fixed income
  • in addition to pairs trading. Before failing in 1998, it had given spectacular returns in 1995-97 periods (up to 40% post-fees). Post Russian default on its ruble denominated debt, LTCM lost more than USD 4bn in 4 months
  • LTCM used proprietary mathematical models to engage in arbitrage trading in US, Danish, Russian, European and Japanese Govt. bonds.  In 1998, LTCM’s positions were highly leveraged (1:28) with ~US$5: 130 Bn of equity and assets
  • LTCM’s model assumed maximum volatility of 20% annually. Based on its models, it was expected to losses more than ~US$500 Mn in once in 20 months
  • It had its bet on convergence of Russian and American G-sec yield, which however diverged
  • after Russian default. Its failure led to a huge bailout by large commercial and merchant banks
  • under the guidance of Federal Reserve
  • It had various risk exposures ….such as Model Risk, Funding liquidity risk, Sovereign Risk, Market Risk

Case studies – Barings Bank

  • Nick Leeson, a trader at Barings-Singapore, led to failure of one of the oldest banks in UK: Barings Bank
  • Modus operandi: Leeson was an employee of Barings-Singapore and was responsible to profit from arbitrage opportunities between Osaka exchange and Nikkei 225 futures prices. Without knowledge of anyone at London HO and Barings Singapore, he started speculative positions and incurred heavy losses. He hid the losses in a fictitious account: ‘88888’ and continued taking more risks to recover earlier losses. Finally his activities were uncovered in 1995 when accumulated losses were US$1 Bn
  • Reported profits: Leeson was considered as a star-performer and reported record-profits for many years. Instead he was hiding all losses in a fictitious account – ‘88888’. Trading transactions reported by Leeson were in nature of ‘Switching’ activities (arbitrage) that are not supposed to generate as high profits as reported by Leeson. This should have raised some suspicion amongst the senior management , but it is clear that they were clueless about true profit generating potential of Leeson’s trading activities. Leeson also maintained over-night open positions & position in options that he was not authorized to do
  • Funding of the losses: London HO: Barings-London funded the position of Barings-Singapore thinking that they are funding the clients (as loans to clients). They were actually funding losses on proprietary book (i.e. trading by Leeson). In 1995, when funding the losses was becoming difficult, Leeson used artificial trades to reduce margin calls from SIMEX
  • Settlements Department was also unable to reconcile the funding transactions but failed to initiate
  • sufficient action
  • Credit department: Since the funding was being recorded as loans to clients, credit department should have paid attention to growth of advances to clients, but it failed to do so
  • Financial control system was inadequate in terms of understanding the requirement of funding by Baring London to Barings Singapore. Surprisingly, even though funding by Barings London to Singapore operations
  • was recorded as advances to clients, it was not reported to regulators as part of ‘large exposure to
  • particular clients’
  • Leeson was allowed to be in charge of both front office and back office, helping him conceal his activities for long. Even though internal audit suggested separation of front and back office function, their recommendations were never implemented. Leeson faced negligible supervision in his back office activities
  • Barings Bank had a Matrix structure of organization, but without proper controls 7 communication channels, the organization structure added to confusion as to who was reporting to whom
  • External auditors ‘C&L Singapore’ once pointed a spurious receivable of Euro 50 Mn from an entity SLK. Instead of going into details of this transaction, the management requested the auditor that no reference to this transaction be made in their report and attributed the spurious receivable to an operational error. External auditors also failed in examining the nature of large funding done by London HO to Singapore operations that was reported as advances to clients but never reconciled to individual accounts of clients
  • Role of Bank of England (regulator for Barings London): BOE knew the extent of profits reported by Barings Singapore and the large exposure of Barings London to Singapore operations. BOE allowed concession to Barings Bank that exposure to Osaka exchange and SIMEX can exceed 25% of its capital base, but failed to put a limit on the extent of this exposure. Consequently, Barings exposure reached 73% of capital base to Osaka exchange and 40% on SIMEX at a point in time
  • In 1995: Market rumors suggested market concerns about Barings positions on Osaka Stock exchange. SIMEX (Singapore exchange) sought an assurance from Barings-Singapore if they would be able to fund margins calls on short notice, if market moves against the bank
  • Important Lessons:
    • Internal controls & systems failed in case of Barings
    • Unauthorized & hidden trading activities by a single trader led to huge losses who was responsible for both front-office and back-office operations
    • Internal departments like credit & settlement dept., external auditor & supervisors failed to detect the true position prior to the Bank’s collapse

Case studies – Banker’s Trust (BT)

  • BT was sued by four major derivatives clients including P&G for misselling (classified as operational risk) i.e. selling derivatives and structured products without fully explaining the risks involved
  • BT suffered huge reputational loss. It also had to settle with four customers leading to monetary losses exceeding US$170 Mn
  • P&G had invested in heavily leveraged IRS that lost substantially after US Fed raised interest rates in 1994
  • (i.e. same time when Orange county lost money on its inverse floaters)
  • Good stakeholder management practices are required to safeguard interests of all parties involved including clients, to prevent such losses

Case studies – Kidder Peabody

  • In 1991 Kidder, Peabody & Co. hired Joseph Jett to their Strips trading desk
  • In his first 6 months the desk did not make money, then reported profits grew quickly ($32 Mn in 1992,
  • $151 Mn in 1993, and $81 Mn in the first quarter of 1994)
  • Jett was Kidder’s “man of the year” in 1993 and was awarded a $9 million bonus (his boss received
  • a $20 Mn bonus in 1993, primarily for overseeing Jett’s activities)
  • It was later reported that Jett’s desk lost $85 Mn during that period and a $358 Mn cumulative write-down. The false profits were the result of an error in their internal accounting whereby a zero-coupon bond was treated like a coupon bond. Thus a forward reconstitution, which exchanges a zero for an identical coupon bond, created instant profits

Case studies – Kidder Peabody (lessons learned)

  • Beware of increasing trading volume. Kidder’s balance sheet was $25 Bn in 1991, $273 Bn in 1992, and $1,567 billion in 1993. Any time notional amount grows dramatically it is wise to double check the business model
  • Most value-destroying activity is not illegal. Kidder and GE shareholders brought suit against Jett
  • for fraud, but it was impossible to prove because Jett was openly engaged in his trading fraud
  • Compensation is an imperfect signal of competence
  • Credentials are imperfect signals of competence. Joseph Jett had an MIT undergraduate degree and a Harvard MBA. Jett’s boss, Ed Cerullo, had a respectable career on Wall Street, and was considered street smart and technically savvy
  • The back office and auditors should not be fearful of traders, and it is management’s job to make this so

Case studies – Allied Irish Bank (AIB)

  • 1993: John Rusnak, who had been working for Chemical Bank in New York,  joins First Maryland Bancorp as a foreign exchange trader
  • 1999: Allfirst is formed from the merger of First Maryland Bancorp (in which AIB first took a stake in 1983) and Dauphin Deposit Corporation (which AIB acquired in 1997). Susan Keating becomes Allfirst chief executive
  • June 2001: John Rusnak is promoted to managing director in charge of foreign exchange trading, in the ‘global trading’ division of the treasury funds management section, or front office
  • Late December, 2001: Allfirst officials start to become suspicious about the sums being demanded by Rusnak to cover his trading
  • January 10, 2002: Keating is appointed to the AIB chief executive committee, the group responsible for developing corporate strategy and overseeing management of AIB group
  • February 4, 2002: Rusnak fails to show up for work on Monday morning
  • February 6: AIB says it is investigating a suspected $750 Mn fraud at Allfirst’s Baltimore HQ, and warns that it will take a one-off charge of E596 Mn ($520 Mn) to cover the resulting losses
  • February 8: Eugene Ludwig, a former US Comptroller of the Currency, is hired to compile a report for AIB on the affair

Case studies – Allied Irish Bank (AIB) (cont.)

  • February 19: AIB chief executive Michael Buckley says that the origins of the scandal might stretch back to 1997, and gives the final figure for losses as $691 Mn
  • March 12: Buckley and AIB chairman Lochlann Quinn offer their resignations to the AIB board, but neither resignation is accepted
  • March 13: The Ludwig Report is published jointly by Ludwig’s Promontory Financial Group and law firm Wachtell, Lipton, Rosen & Katz
  • March 14: Allfirst and AIB announce that six executives who were responsible for oversight of Rusnak’s activities are to be dismissed. A number of organizational and structural changes are also announced, including the appointment of an individual to oversee risk management across the AIB group
  • March 17: AIB denies rumors that Allfirst CEO Keating is about to step down. Later newspaper reports claim that Keating has been given one year to get Allfirst back on track

Case studies – Allied Irish Bank (lessons learned)

  • Allied Irish Bank lacked clear reporting lines and structure
  • There was inadequate supervision of employees and failure to control the business that an overseas office was engaged in
  • Proprietary trading is very risky – and it is not just a question of market risk. A relatively small outfit without access to the information, expertise and economies of scale of much larger financial institutions may find it difficult to manage and control a proprietary trading business effectively. The potential operational risks may outweigh the potential market returns, perhaps greatly
  • Risk management architecture is crucial – The Ludwig report concluded that risk management structure and practices within Allfirst's currency trading operations were seriously flawed. The relationship between parent company and overseas units needs to be clear
  • In some areas, it was not clear who was accountable to whom, and the reporting lines within Allfirst and between Allfirst and AIB were blurred
  • Strong and enforceable back-office controls are essential – Unlike Barings’ Singapore unit, there were independent back-office staff overseeing Rusnak's activities. But the Ludwig Report says that Rusnak was able to persuade back-office staff to let normal procedures slip. Back-office staff must be empowered to stand by their guns if they have concerns about trading activities.

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