The Return of The Rogue

Silicon Flat IronsJune 5, 2009

Kimberly D. Krawiec

What is Op Risk?

The risk of loss from inadequate or failed internal processes, people, and systems or from external events

Historically, a residual risk category i.e. not market or credit = operational

New focus & importance, thanks to Basel II and market changes

Basic Thesis

Bad – maybe worst of all alternatives Require capital cushion, but use internal

models

Limited effectiveness Banks w/ highest op risk levels are least

likely to credibly assess

Basic Thesis

High costs: Definition, modeling, and data problems Enforcement likely to be lacking Room for interest groups –lawyers,

accountants, risk management experts – to capture definition and management

Incentive to “manage the model,” rather than op risk

Alternatives

Status quo Plausible deniability re: other limits

Do it better Future:

incentivize market-based solutions (e.g. insurance)

Non-financial metrics Other proposals – compensation

revisions

Jerome Kerviel – Societe Generale

Authorized to engage in client sales and arbitrage

Not authorized to take directional positions

Fraud = series of unauthorized directional positions in equities and equity futures

Concealed by a series of fictitious transactions

Note that subsequent investigation turned up numerous violations

3 Concealment Techniques Entry then cancellation of fictitious

trades 947 transactions

“matched” trades – i.e. purchase/sale of equal quantities at different “off market” prices, thus generating gain or loss as needed 115 transactions

Intra-monthly provisions 9 transactions

Actual v. Authorized Earnings

Fictitious Transactions

Nicholas Leeson

28-year-old trader who never graduated from college

Barings Bank desk at the Singapore International Monetary Exchange

In charge of both trading and settlement

Nicholas Leeson

Accused of losing $1.3 billion

Charged with forgery and trading violations on December 1, 1995

Sentenced to six and a half years

Leeson and Barings

Short Straddles: Profitable (Premium) if Nikkei traded

within or near strikes between 18,500 – 20,000

Leeson and Barings

4Q 1994 - January 1995 Nikkei in a range of 19,000 – 19,500 Recall that Leeson’s goal = 18,500-

20,000

Nikkei 225日経平均株価

Leeson and Barings

January 17, 1995 Kobe Earthquake Nikkei dropped sharply Leeson goes long

Leeson and Barings

January 20 – February, 1995 Leeson launched aggressive buying

program: 55,206 March contracts and 5,650 June contracts

Leeson and Barings

Barings collapsed – could not meet huge trading obligations

Outstanding futures positions of $27 billion (Barings’ capital was $615 million)

1050023ST 17

Osaka Securities Exchange10 largest net Nikkei 225 futures positions

0 5,000 10,000 15,000 20,000

17.02.95

Barings

Paribas

Salomon

JP Morgan

BNP

SBC

Yamaichi

Soc Gen

Tokyo Mitsubishi

BZW

Do it better

Improbable profits Esp. in light of experience level and

authorized trading strategy Unusual trades (real and/or fictitious)

in terms of type and/or volume Back office issues

Bully back office, evasive answers Ignored inquiries from regulators,

exchanges, competitors, other employees