Book Excerpts, Case Studies and Standards
The following resources are available free of charge. These reading list items should be combined with The Essentials of Risk Management book.
• Bankers Trust
• Bankgesellschaft Berlin
• Continental Illinois / Penn Square
• Credit Lyonnais
• Long-Term Capital Management (LTCM)
• National Australia Bank - FX Options
• Orange County
• Riggs Bank
Standards: Governance, Best Practices and Ethics:
Case Study Overview
- Unauthorized trading in derivatives by Nick Leeson in its Singapore subsidiary completely wiped out the bank’s capital of £200 million
- Failures: No segregation of duties. Internal audit report not heeded. Doubts raised by Singapore Futures Exchange (SIMEX) ignored. Excessive profits not investigated.
• Over $1.1B loss, plus $340MM fine
- Trading fraud spanning 11 years within the US subsidiary, followed by a cover-up among senior management in Japan
- Japanese court fined eleven senior managers $775MM; credit rating downgrades; forced exit from US markets
- Segregation of duties failure: US Treasury securities trader also supervised the securities custody department. Secret sale of securities masked trading losses.
- Hedges adequately transferred the market risk created by their underlying commercial forward contracts, but MGRM exposed themselves to risk of not being able to fund margin calls if the value of the hedges fell.
- Company held enormous and out-sized positions in the markets, hence liquidity was insufficient to allow timely risk management
|National Australia Bank - FX Options
- Four currency traders smoothed profits and concealed losses for over two years, and possibly five years. The traders entered fake transactions into their trading system. Various methods were used which exploited gaps in many controls: incorrectly recording genuine transactions, entering false transactions, and using incorrect revaluation rates. Exploitation of end-day timing gap between position marks and back-office controls. Use of internal transactions that received less scrutiny.
- While size of positions was partially masked, VaR limits were still breached continuously but did not trigger an investigation due to deemed lack of reliability of VaR calculation
- Warning signs raised in internal audit report did not reach senior management; concerns raised by counterparties not sufficiently investigated
- Desk supervision was inadequate to monitor trading vs approved strategies
|Product Design and/or Sales Practices
- Bank sued by four of its major clients, who asserted that Bankers Trust had misled them with respect to the riskiness and value of derivatives that they had purchased from the bank.
- Reputation damage greater than financial loss
- This prosperous California county filed for bankruptcy after losing $1.6B on leveraged derivatives transactions involving its major investment pool.
- Supervision of the County treasurer lacked financial sophistication and received inadequate reporting; Treasurer’s superior performance in prior years resulted in excessive trust.
|Conflicts of Interest
- Very rapid pace of acquisitions and poor integration of acquired companies.
- Optimistic interpretation of accounting rules, facilitated by lax external auditors. WorldCom eventually made a $9 billion adjustment for the period from 1999 thorough the first quarter of 2002.
- Potential conflicts of interest due to multiple relationships between different arms of large integrated banks (investment, trading, lending, private banking), WorldCom and WorldCom’s senior management.
- Conflicts of interest between equity analysts responsibilities to investors and power attracting investment banking business. (In December 2002, Jack Grubman of Citigroup was fined $15 million and banned from securities transactions for life by the Securities and Exchange Commission).
|Credit Boundary Events
- E 2B to E 37B (best estimate E 3.7B to E 8B)
- Credit risk boundary event
- Bank created real estate funds, heavily concentrated in Berlin, with mispriced guaranteed returns to investors
- Complex private/government management structure created unusual incentives for senior management
- Regional political upheaval
• Over $20B
• Taxpayer bailout to avert bankruptcy caused by rapid growth of a very poor credit portfolio between 1988-1993 as CL strove to become a major global competitor.
• Confusion over mission: support French economy/gov’t or behave commercially
• Confusion over sources of strength: French taxpayer or own capital
|Long Term Capital Management (LTCM)
- Liquidity squeeze of a major hedge-fund via margin calls on trading positions; pricing transparency was reduced in thin markets; market liquidity made worse because counterparties were reluctant to buy positions or securities fearing that LTCM would dump more on the market rapidly.
- Systemic risk if cross-defaults provisions were triggered; prompted Federal Reserve to broker an industry agreement to save LTCM through a $3.625B recapitalization
- LTCM models did not work if prices were discontinuous
|Continental Illinois/Penn Square
- Bail-out of top-10 US bank due to a liquidity crisis prompted by flight of wholesale investors/creditors spooked by the bank’s excessive exposure to energy and less-developed countries (1982 collapse of Penn Square affiliate and the Mexico default)
| Inadequate Risk Oversight
| Riggs Bank
| • Oldest bank in Washington D.C. was fined $25 million for not reporting suspicious transactions in accounts by the dictator of Equatorial Guinea, the former president of Chile Augusto Pinochet, and by the Saudi Arabian ambassador to the United States.
• Riggs violated Know‐Your‐Customer (KYC) and anti‐money laundering (AML) laws, maintained a dysfunctional AML program despite frequent warnings from regulators, and allowed or, at times, actively facilitated suspicious financial activity.