Heads I win, tales you lose

When something like the recent UBS scandal comes to surface, the questions that we ask are often the same.

When something like the recent UBS scandal comes to surface, the questions that we ask are often the same: How is this possible that such a big event (and trades) can take place in a bank without the directive body of the bank knowing of it? Didn?t the bank learn anything from the crisis? Will this happen again?

Guinness World Records online says that the largest single trading floor in the world belongs to the financial service firm UBS (formerly known as UBS Warburg) in Stamford, Connecticut. It measures 125 m (410 ft) long by 69 m (227 ft) wide which equals an area of 8,625 sq m (93,070 sq ft) and hosts 1,400 traders sitting alongside 5,000 computers. There are approximately 126,000 daily transactions with an average value of $399 billion.

With a 10 hour work day, this translates to an average of 90 transactions per trader per day. That?s about 9 per hour. Add in the extreme leverage that you can get from derivative securities (such as options, futures, swaps, etc), and the high level of complexity of these instruments, and you can quickly see how difficult it is for a bank supervisor to really understand what is going on. Events like this can happen without a bank?s management knowing it do.

There?s no doubt that bank supervisors at UBS acted with professionalism as one would expect from one of the most respected banks in the world. However, there is something that it is not

perfectly clear at this time. If we look at the almost 10 days that passed between September 6, the date when the trader allegedly wrote on his Facebook wall that he needed a ?miracle? (that was the day when the Swiss National Bank (SNB) imposed a ceiling on the Swiss

exchange rate) and September 15 (when this episode was made public), we cannot not help but ask ourselves: what happened in those 10 days?

Did someone at UBS know about the SNB position and hope for a market reversal? Or was the bank completely in the dark about it? The first question would imply that there are supervisory and control issues that UBS needs to resolve. The second leaves me thinking that Mr Adoboli?s friends on Facebook may have known more than bankers at UBS about the trade!

Both hypotheses are scary and I?m sure that UBS has the answers to them. It would be in the best interests of UBS, for what it is and what it wants to be, to clarify its position sooner rather than later.

Three years have passed since the Lehman Brothers debacle and the beginning of the financial crisis. As much as banks have learned important lessons from the past, the real cause of the crisis is that incentives are misaligned with value creation. Today?s incentives come more from profits or stock price increases, which does not always represent a positive value creation. As long as bankers? salary and bonuses are not linked to real value creation, these episodes are bound to happen again and again.

Nick Leeson managed to sink Baring Securities all by himself. Jerome Kerviel lost $6.8 billion (but he was probably not alone as he states that his superiors knew). Now, Mr Adoboli from UBS. And, who knows how many rogue traders did not make it to public fame simply since they actually made money! Mind that even in the case that they made money, the problem remains the same: too much risk. We must remember that given a relatively good base-salary, a trader can only increase it more through money-making transactions, which often entail risk. As long as banks and financial institutions do not solve this incentive issue, essentially that traders are encouraged to take on a large amount of risk, the issue is still standing.

Interestingly enough, banks are trying to tackle this issue in different ways. Tighter control and tighter limits on trades as the ones already put in place are a good start. But what about the possibility that a trader decides to do something that he or she is not supposed and gets a manager to actually do it and to hide it,

despite the bank?s tight control?

Banks realising that this is possible can buy insurance for such losses. Financial companies learned to distinguish financial losses as the one allegedly suffered by UBS between market risk and operational risk. Market risk is broadly defined as the risk that prices (stock, currencies, interest rate, commodities) move in an adverse direction and cause losses. Operational risk is about people, systems, and processes, and that includes, among other things, the possibility that some internal control (for example: risk control on a trader?s position) does not work properly.

It will be interesting to learn how much of the $2 billion will be charged to adverse price movements and how much will be billed to operational losses. If UBS has bought insurance against these losses, and if UBS can prove that Mr Adoboli?s losses are operational, it may get some money back. But the very fact that banks could get some of their money back, only reduces the possibility of reform to align incentives with value creation, making me believe that we will have more rogue traders in the future.

The author is a professor of finance at IMD in Lausanne, Switzerland

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First published on: 17-11-2011 at 03:10 IST