This is my Sunday Washington Post column from last weekend:

There are no rogue traders, there are only rogue banks

In 1995, derivatives broker Nick Leeson of Barings Bank engaged in “unauthorized” speculative trading. The massive losses — 827 million pounds — led to the collapse of Barings, the oldest investment house in Britain.

In 1996, another rogue, Sumitomo Bank copper trader Yasuo Hamanaka, lost at least $1.8 billion. Some reports put the true losses at $4 billion.

Then, in 2008, Jerome Kerviel of Societe Generale lost 4.9 billion euros — about $6.8 billion.

And just last week, UBS suffered a $2.3 billion hit connected to an alleged rogue trader.

As history teaches us, there are no rogue traders; there are only rogue banks.

Here’s a news flash: If you issue credit, your working assumption must be that there are unqualified people who will try to borrow money from you. It is the job of every lending facility each and every day to separate the qualified borrower who has the capacity to service that debt from the unqualified borrowers who do not. This is why there is no such thing as a predatory borrower — banks must assume that all borrowers are predatory and protect themselves. This is why lenders — at least before 2002 – inquire about income, employment history, credit scores, other debt, etc., before making a mortgage loan.

Similarly, if your business involves the use of leveraged capital for speculation by your employees, then it is your job to know which, if any, of your people are not competent. It’s a simple mathematical fact that some of your traders will take losses; in some cases, enormous but manageable losses. Your job is to identify these people and move them to other professions.

There will be a small number who will try to hide their inabilities. Your job is to separate the qualified from the unqualified, to watch over the full lot of traders and speculators in your employ. Toward that end, you will establish trading limitations, leverage constraints, risk parameters. Traders must stay within the limitations you impose on them: money lines, maximum drawdowns, loss limits.

Thus firms that highly leverage their capital to put it into the hands of a few thousand employee speculators have a crucial job: They must ensure that capital is being precisely and properly managed. They must make sure that risk levels are tolerable, that proper controls are in place, that their IT systems and internal technology can track what is happening, in as near to real time as possible.

This is not easy. It is a complex set of processes that requires constant vigilance. It must be reflected in the corporate culture from the top down. And it becomes more and more complex as the size of the organization grows. The assumption must be that every employee is a potential rogue trader.

Banks are supposed to have expertise in preserving capital and managing risk. If they cannot discharge those simple duties, then perhaps they should not be in the business of finance. Most of all, they should not be engaging in behavior that puts taxpayer money at risk.

Anyone who runs a shop that has a proprietary trading desk is obligated to do everything in his power to prevent that single employee from bringing down the company. It’s not too hard to see that anyone who earns a bonus by risking the firm’s capital is a potential disaster.

With this backdrop, how is it that we seem to have a major rogue trader pop up every year or so? The simple answer is, a rogue trader who nets massive losses is a complete and utter failure by the bank’s management. UBS was unable to track its capital on a timely basis, as its London trader hid losses for more than three years. So much for real-time supervisory tracking.

The arrest of a rogue trader is a red flag. The discovery of the fraud is a company admission of being poorly managed. The board of directors should be holding senior management just as responsible as the trader for the losses. They may not have committed the same legal fraud — hiding the trades — but they should be sacked for gross dereliction of duty.

Understand what this means within the broader context of our financial sector’s not so innocent foibles: Any firm that hires “robo-signers” is just as bad as a firm that has rogue traders. Both actions are an indictment, an admission of failure and of managerial incompetence. Each illegal act represents a crucial failure of risk management, of legal compliance, of the ability to do jobs safely and within the law.

In an era of bailouts on the backs of the taxpayer, it points to a simple reality: Firms must decide whether they are going to sacrifice profit in pursuit of safety, or sacrifice safety in pursuit of profit. Whatever they decide, it is not the responsibility or obligation of taxpayers to backstop these choices.

Consider the choices made by management: The collapse of firms such as AIG, Bear Stearns and Lehman Brothers were caused by the same sort of poor judgment as UBS’s $2 billion in losses — only the rogues gallery there included the senior-most managers of the firms. Alan Greenberg exhorting his staff to focus on reusing paper clips, while the mortgage syndication division lost billions of dollars. Dick Fuld surrounding himself with yes men while the firm’s leverage and risk exposure went through the roof. Tom Savage, president of AIG’s Financial Products, calling derivative underwriting free money.

Paul Volcker, arguably the greatest central banker in history, has persuasively argued that proprietary trading should not be part of the insured depository banking sector. I utterly agree with Fed governor Thomas Hoenig, who has described the banking sector as “more akin to public utilities” than independent entities. Want to be independent to pursue proprietary trading? Let’s drop their FDIC insurance and see how far their reputations carry them.

The next crisis — the one after the present one in Europe — is where I expect to see the ultimate damage wreaked by rogue bankers.

The bailouts have created a moral hazard, where leveraged speculators and rogue bankers know that the state will bail them out. This is unacceptable. There is no reason that taxpayers should be responsible for any rogues, traders or bankers.

Perhaps UBS’s failure to prevent this did us a favor. It points out that Volcker is right: Any firm that can blow itself up should not qualify for taxpayer guarantees. Lenders, underwriters and mortgage originators are in the business of using their capital to earn a fair return safely. That government-backed insurance should be available only to depository banks, not firms associated with speculative traders.


Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture.

Category: Apprenticed Investor, Bailouts

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

17 Responses to “There are no rogue traders, there are only rogue banks”

  1. crutcher says:

    Keep the great WaPo columns!

  2. Moss says:

    ‘The bailouts have created a moral hazard, where leveraged speculators and rogue bankers know that the state will bail them out. This is unacceptable. There is no reason that taxpayers should be responsible for any rogues, traders or bankers.’

    So true but when these very same bankers are named as Treasury Secretary no different outcome can ever be expected. Robert Rubin, Henry Paulson, Tim Geithner et. al. are all bankers who have the banks and the bankers benefactors as their primary constituents. The Federal Reserve is an opaque entity owned by the banks and their primary concern are their member banks and any counter party, private, public or International. Taxpayers are not part of this cabal.

  3. Steve Barry says:

    Great piece…you back up your arguments well, except one line left me with more questions than answers:

    “The next crisis — the one after the present one in Europe — is where I expect to see the ultimate damage wreaked by rogue bankers.”

    Seems capricious…why the next one and not the current one? Are they going to be able to kick the can one more time? Why? When do you expect the next crisis? Will that one take the system down?

  4. rd says:

    Isn’t one of the purposes of double-entry book-keeping to prevent this type of “rogueness”?

    I initially thought that he had made some massive trades over a handful of weeks before somebody might have caught on in accounting, in which case he would have been a true rogue. But then I saw the more in-depth articles indicating that it was a cumulative loss over three years. My reaction was: Huh? How could that be?

    So my conclusion was that management was either grossly incompetent or complicit. There is no other way that this could have gone through several years of audited books.

  5. sydneybound says:

    There’s another guy out there who thinks along the same lines as you.

  6. gkm says:

    Well written.

  7. FNG says:

    While I agree with your conclusions I can’t help but wonder “Is there more to this?” Was it possible that this individual and the others you mentioned had along with the “publicly known” directives to perform as a trader for their respective firms another “private” set of of directives from their superiors. One that demands and rewards “heavy duty risk”. The level of risk that cannot be publicly acknowledged, yet leads to the profits that are required to”rise above” in the corporation. An almost black-ops operation whereby the company can disavow any knowledge of such an operation. It would be interesting to review the successful “rogue trades”…if it is possible to determine which ones in fact would fit the “rogue definition”. I imagine the definition of “rogue” is based on whether or not you made the company money.

  8. SOP says:

    Dave Barry : “Seems capricious…why the next one and not the current one? Are they going to be able to kick the can one more time? Why? When do you expect the next crisis? Will that one take the system down?”

    — This essay might help

    “Consider a flame; a jet of methane, for example, injected into an oxygen-rich atmosphere and set alight. Now try to describe the shape and structure of the flame mathematically, in a way that will allow you to accurately predict how its shape and structure respond to changes in various conditions…

    Let us try to apply this same approach to a truly complex system: the economies of US and Europe, in the state in which we currently find them … Specifically, let us try to characterize the effect of the continuous monetary infusions, bailouts, and stimulus spending.

    The economics profession has failed to do this and so amateurs are forced to step into the breach. The economists’ usual excuse is that it’s all very complicated; sure it is, so is a gas flame…”

  9. SOP says:

    Sorry Steve Barry… confused you with my favorite editorial commentator for a second ;)

  10. ToNYC says:

    There may be only “rogue banks”, but the rogues are kept in play only by the three rogue enablers of Tim, Ben, and Bill, head of NY Fed. LaGarde had a Euro better plan for the disintermediation of free market Capitalism, so DS-K was led to any well-known parachute.
    Great hammering home the tittle; the church bells should be ringing on the hour until the moral force of non-violence in Capital formation begins by ripping the FDIC out of the rogue’s lungs.

  11. I agree, Barry…as an individual trader, you have given me an idea…that is to ask myself, “Would I honestly hire myself as my financial management firm which would be responsible for making all my trades?…”What trading guidelines would I demand that I must adhere to?” If I want stringent rules for my bank, it stands to reason that I should also have them for myself.

  12. Bob A says:

    Speaking of “blowing itself up” isn’t this what BofA seems to be trying to do with it’s $5 debit card fee? It seems they have Netflix envy

  13. Molesworth says:

    Good one Bob A. I mean, really, what are they thinking?
    Also, HP
    The question I’m wondering is when the next one comes, will our govt finally have the guts to go Swedish?
    It’s my understanding that it took Sweden 2 meltdowns to finally go Swedish.
    And we’ve probably got another collapse sooner rather than later.
    Too many dicey situations: Europe (over levergd/under capped banks own Greece), China (stimulus spent on empty cities using dodgy acctg) and USA (pol gridlock and recession around the corner.)
    Something is going to give and I expect it’s going to be big. Worries The Economist too.

    BHO needs to be listening to Volcker, Bair and Warren. Not Geithner.
    Tax transactions. I could care less if I had a $0.001 or a $0.01 tax on my trades, even $0.10 would not change my behavior, but it might dampen HFT some and would begin to fill our coffers again.
    Reinstate Glass Steagall.
    Banks as utilities, not as casinos gambling with govt covering their losses.

  14. philipat says:

    Excellent piece Barry. The consequences and solutions are obvious but I am assuming that so long as Congress remains a wholly-owned subsidiary of Wall Strret and the Corporatocracy, nothing is going to change. Which I find both frustrating and very sad in terms of what the US has become.

  15. dsawy says:

    The repeated instances of gross mis/malfeasance on the part of bank management that Barry has highlighted (repeatedly) begs a question:

    Just what are these bank managers doing with their time if they’re not actually managing their departments and employees? Are they simply assuming that their employees are doing what they’re supposed to do because said employees are all chasing after the big bonus package? I’ve never had a job where my boss just let me wander off and do something as large as these traders are doing without having to at least answer inquiries of “Hey, what are you doing and how’s it going?” every other week or so.

    If the bank managers aren’t actually doing their job, then why bother employing them and, by extension, why suffer the expense of their pay/comp package?

  16. Expat says:

    I knew a trader who signed a rock-solid contract with a bank. 10% of whatever he made irrespective of how the bank did or what happened on the 1st of January the following year. He made a huge play and booked $20 million. In February, at bonus time, his book was down about $80 million because he had backed off the play (basically he had propped up the market until year end) and taken his hits. He forced the bank to pay him his bonus and then got fired. A classic example of the basic design fault of the system.

    Of course, the amount involved was peanuts compared to what the CEO’s and senior executives at the major banks lost. But they walked away with hundreds, if not billions, in accumulated bonuses and deferred compensation. Why didn’t Kerviel get bailed out, asked to resign, and then get paid off? He lost a hell of a lot less than the others and probably broke fewer laws and rules.


    BR: Not sure I follow your math — if he was down $80M he would get zero bonus.

  17. Expat says:

    Hi Barry, the trader put on a November play (took on pretty much the entire market) and then had to hold the position (keep building it) to stay in the black. Closed his book on 31 Dec. In January he took his foot off the pedal and dumped a quick $80, but the loss was in the following year. So he made $20 in year one and collected his bonus. He lost $80 in year two and got fired.

    Score Card: Bank -$60
    Trader: +$2