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Of Circular Frequencies
The story is familiar to anyone reading the papers: A trader working for a European bank establishes a huge number of risky trades. Through his knowledge of the system, he manages to mask his activities in order to make far larger, far riskier bets than would be approved by management.
He makes a lot of money for a while and then, in a flash, he loses vast sums. The bank collapses and international markets plunge. Regulators swoop in and create new laws requiring more stringent audits. Senior management promises that they have learned their lesson and that they will never let it happen again. Of course, it always happens again. Anyone who has spent at least a decade in the risk management profession will notice that every cataclysm, no matter how many times it has happened before, comes as a complete shock. It is treated as an unforeseeable surprise by the senior management of the firm involved. If the economists get involved, they will say that it is a matter of "Knightian uncertainty," meaning that, even when we know the odds of a coin flip, we still do not know whether it will land on heads or tails until after it lands; therefore, how can we possibly foresee a rogue trader?
Regarding the story above, it sounds a lot like the recent events at SociétéGénéral, where trader Jérôme Kerviel managed to hide $70 billion in unauthorized trading positions, which ended up costing the bank approximately $9 billion in losses. In reality, however, it refers to the downfall of Barings Bank in 1995. Same story, different decade. From 1993-1995, Nick Leeson, a trader and manager at Barings, managed to hide roughly $7 billion in unauthorized trades by using a loophole in the audit system. Leeson, like so many who take big risks, was incapable of seeing into the future. When markets dipped, Barings lost $1 billion. Unfortunately for Barings, which had operated successfully for more than 200 years, $1 billion was a lot of money in 1995. In the end, ING bought Barings for £1. It should not come as a surprise to anyone that a rogue trader can thwart the system of checks and balances that purportedly prevent them from taking excessive risks. What should not be accepted is that such massive losses are a surprise. They are, in fact, common. Long-Term Capital Management blew up in 1998, losing approximately $100 billion. Amaranth Advisors LLC blew up in 2006 losing approximately $9 billion. The subprime meltdown has caused an estimated $300 billion in losses. Large, risky bets cause huge losses ... frequently. We need to learn two things from these losses. First, huge losses are not always rare. Certain kinds of catastrophes can and do occur with a surprising frequency. There is no cosmic stop-loss on our existence. Second, we need to learn that simply putting controls in place is not enough to stop catastrophic losses. There is no audit process, no Sarbanes-Oxley law crafted so well that it can't be circumvented by some conniving genius. Good risk management involves being realistic about the amount of risk one faces. If others refuse to learn from history, we should at least attempt to diminish the level of delusion. BEAUMONT VANCE is the risk management columnist for Risk & Insurance®. He manages risk for a leading financial company. April 15, 2008 Copyright 2008© LRP Publications |
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