The Return of The Rogue

1. Silicon Flat Irons June 5, 2009 The Return of The Rogue Kimberly D. Krawiec

2. 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

3. 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

4. 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

5. 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

6. Jerome Kerviel – SocieteGenerale • 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

7. 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

8. Actual v. Authorized Earnings

9. Fictitious Transactions

10. 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

11. 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

12. Leeson and Barings • Short Straddles: • Profitable (Premium) if Nikkei traded within or near strikes between 18,500 – 20,000

13. 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

14. Leeson and Barings • January 17, 1995 • Kobe Earthquake • Nikkei dropped sharply • Leeson goes long

15. Leeson and Barings • January 20 – February, 1995 • Leeson launched aggressive buying program: 55,206 March contracts and 5,650 June contracts

16. Leeson and Barings • Barings collapsed – could not meet huge trading obligations • Outstanding futures positions of $27 billion (Barings’ capital was $615 million)

17. Osaka Securities Exchange 10 largest net Nikkei 225 futures positions 1050023ST.xls*Osaka Sec Ex?Chart 2 1050023ST

18. 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