I tell my class that a crisis can spring from the most unexpected sources. You never see the lightning that strikes you. Now we focus on some of the most obvious risks, such as a sovereign debt default. As Howard Schneider reported in the Washington Post yesterday, “European banks are facing a reckoning over hundreds of billions of dollars in loans extended to the continent’s cash-strapped governments with potential losses so large, if countries default, that some financial firms could be put out of business.”
Yet danger lurks in the form of many types of operational risk.
Normally when things unexpectedly go wrong in a single company, the system is able to contain the problem–see Long Term Capital Management. But this is not an obvious assumption in the case of large, complex financial institutions (LCFIs) or “universal banks.” They are so tightly coupled, or interconnected, that the failure of one can sometimes cause the failure of all–usually through a sudden and unmanageable liquidity crisis. Today is the three anniversary of the bankruptcy of Lehman, which provides just such an example (though Lehman did not fail because of an unexpected operational risk).
But it could have. The 233-year-old Barings Bank was brought down overnight by the trading activities of a 28-year-old trader, Nick Leeson, in 1995. The failure was contained by British regulators and ING, which bought the bank for the princely sum of £1, but Barings was minute compared to the LCFIs operating today. There have been many other prominent examples, one affecting Daiwa Bank in New York in 1995 ($1.1 billion), one in the late 1990s costing Sumitomo $2.6 billion, and one in France, where Jérôme Kerviel, described by the Wall Street Journal as the “ultimate rogue trader” and by the Financial Times as “the all time champ,” lost $7.2 billion at Societe Generale in 2008 (€4.9 billion) (Kim Krawiec posted a series on the whole Kerviel story on this blog; the last post is here). The list of other cases is not short.
Today we learn that UBS, Switzerland’s largest bank, and 20th largest in the world (at about $1.3 trillion in assets) has just suffered a similar experience at the hands of a rogue, 31-year-old trader in London.* Because of UBS’ size and unusually well capitalized condition, this problem will likely be contained (though its stock dropped dramatically on the news). It is worth noting, however, that UBS was fined £ 8 million less than two years ago for a prior episode of rogue trading. And just a few years earlier UBS had to pay Sumitomo $85 million for its part in the rogue trading episode already mentioned. This raises the question whether rogue trading is really controllable at all, and whether it is really only UBS that does not seem to manage operational risk very well.
The UBS incident is another reminder of just how fragile our system is, and why it is so important to insulate our taxpayer-backed banks from the high-risk-taking activities of trading and investment banking. As the Wall Street Journal, with deliberate irony, headlines its story today: “What Do You Call A ‘Rogue’ Trader Who Makes $2 Billion? A Managing Director“!
* Loss subsequently revised to $2.3 billion.