The Inaugural ESRC People Risk Seminar

Centre for Risk Banking and Financial Services, Nottingham University Business School

Markus Krebsz – Author, Strategic Advisor & Head of Risk 4th December 2013

www.krebsz.net

- A People Risk analysisContentsThe Tip of the Iceberg

What is a “Rogue” Trader?

What do they look like?

The Rogue Traders’ Playground

Men behaving badly

Evolution and “Strike-it-rich” birds

Risk-aversion & Gambling

Avoiding losses at all costs

Lessons learnt

Research Ideas

Publications

Contact

References & Further reading

(Source: “Rogue Trading – Risk Management: Controls & Culture”, GARP 2012)

• This is just the tip of the iceberg...

• Original size vs. Reported size

• Smaller rogue trades:

don’t often make it to the news

might never be discovered

• Appear in cycles

The term was originally coined by Eddie George, a former governor of the Bank of England:

He described Barings Bank as having been the victim of ‘massive unauthorised dealings’ by ‘a rogue trader’.

‘Rogue Trader’ is also the title of Nick Leeson’s memoire.

= An authorised employee executing unauthorised trades.

Rogue Traders’ gallery

Joseph Jett, $74m

Nick Leeson£830m

Toshihide Iguchi$1.1bn

Yasuo Hamanaka$2.6bn

John Rusnak$691m

Team of 4 RoguesAU$360m

Jérôme Kerviel€4.9bn

Kweku Adoboli$2.3bn

Valdemort / London Whale$6.2bn

To be continued…

Some Stats:• Single largest trading

floor (Guinness book):Size of 2 football pitches

• 5,000 monitors, 2,000 computers,1,400 seats

• 1,689,000 transactionsper day

______________________Q: How does one stand out

working there?A: By making money -

Loads of it!

• They have worked in the back- or middle office (= detailed knowledge)

• They are outsiders (or are seeing themselves as such) and act mostly alone

• They are charismatic

• They are clever

• They are control freaks

• They CANNOT STOP and CARRY ONuntil the losses spiral completely out of control or until being caught.

(Source: John Gapper, How to be a Rogue Trader, 2011)

Most of them are male, although there are some know female rogue traders.

The Six Key Personality Traits of Rogue Traders:

• If plenty to eat: birds are risk-averse

• When starved: birds are gambling in search of a bigger pay-off (i.e. food)

• The behavioural driver behind is known as the negative net energy budget.

• This is not limited to birds – similar behaviour can be seen in mammals (shrews) and bumblebees.

• Choices are instinctive rather than intellectual and make sense for species.

• The greater the ‘evolutionary fitness’ of an animal the less risks it needs to take.

Option #1 Always 2 seeds

(100% probability)

Option #2Either 4 seeds

or none (with 50/50 chance)

Animals facing risk of starvation will gamble to surviveYellow-eyedJunco (sparrow),Mexico & US

(Source: Barry Sinervo, ‘Optimal Foraging Theory: Constraints and Cognitive Processes’. )

The model for animals applies equally to humans

Daniel Kahneman and Amos Tversky, two Israeli psychologists, identified loss aversion in humans at about the same time that Caraco and his fellow biologists were observing yellow-eyed juncos. Their findings, published in 1979 in Econometrica, won Kahneman the 2002 Nobel award for economics.

Rogue Traders do what comes naturallyKahneman and Tversky discovered that risk aversion reverses when humans are in loss, just as it does with animals.

“The desperate scramble to avoid losses at all costs is a

defining characteristic of a rogue trader.

The rogue trader may appear to be acting strangely, but he does what comes naturally.”

– John Gapper

• Firms need to ensure authorised employees execute no unauthorised trades – it is part of their business.

• Hence, they need to put appropriate controls in place AND need to ensure these work as anticipated – i.e. frequently test & amend them.

• Two most important employees are: Rogue trader and Whistle-blower

• Two key objectives: Survival and Survival with a Profit. Rogue traders threaten both – and in some cases (i.e. Nick Leeson/Barings) can kill firms off.

Firms need to see the banana skins in their path

and actively manage conduct risk.

Employing rogue traders as authorised employees

If it smells “fishy” – it probably is!• Detective controls vs. Preventive controls• Back-office staff promotion to Front office

needs very careful, close & continuous supervision• Big data can help identifying illogical trades, but

most banks systems are not able to recognisesuch trading and behavioural patterns (yet)

• More and frequent use of Psychometric testing and Personality assessments

• Increasing the level of team-work in the front office,including proven control mechanisms such as the four-eye principle

• More use of common sense, gut feelingout-of-the-box thinking and instinct is needed

Some of which may be somewhat controversial...• Correlation of Economic cycles vs. appearance of rogue trade events

• Influence of Trading floor environments on the ability to make emotionally balanced decisions

• Regular analysis of ‘Moral DNA’ as potential predictor for rogue behaviour

• Development of behavioural pattern recognition based on big data to detect possible rogue trading activity – and prevent them or at least in order to have some sort of damage limitation

• Frequent/Regular use of lie detector tests as part of behavioural staff screening

• Protective mechanisms and working incentive structures for whistle-blowers

Markus Krebsz

krebsz@web.de

+44 79 85 065 045

www.krebsz.net (LinkedIn)

www.people-risk.net (Private website)

www.riskrewardlimited.com (Company’s website)

• Mitchel Abolafia. Making Markets: Opportunism and Restraint on Wall Street. Harvard University Press, 2001.

• Australian Prudential Regulation Authority. Report into Irregular Currency Options Trading at the National Australia Bank. 2004.

• Bank of England Board of Banking Supervision. Inquiry into the Circumstances of the Collapse of Barings. July 1995.

• Daniel Bernoulli. ‘Exposition of a New Theory on the Measurement of Risk’. Econometrica, January 1954.

• Thomas Brennan and Andrew Lo. ‘The Origin of Behaviour’. Quarterly Journal of Finance, 2011.

• David Bullen. Fake: My Life as a Rogue Trader. Wiley, 2004.

• Thomas Caraco, Steven Martindale and Thomas Whittam. ‘An Empirical Demonstration of Risk-Sensitive Foraging Preferences’. Animal Behavior, August 1980

• John Kenneth Galbraith. The Great Crash, 1929. Houghton Mifflin, 1954.

• John Gapper and Nicholas Denton. All That Glitters: The Fall of Barings. Hamish Hamilton, 1996.

• John Gapper. How To Be A Rogue Trader (Penguin Specials) (Penguin Shorts/Specials). Penguin Books Ltd. Kindle Edition.

• Azar Gat. ‘The Human Motivational Complex: Evolutionary Theory and the Causes of Hunter-Gatherer Fighting’. Anthropological Quarterly, 2000.

• Daniel Kahneman. ‘Maps of Bounded Rationality: A Perspective of Intuitive Judgement and Choice’. Nobel prize lecture, 2002.

• Daniel Kahneman and Amos Tversky. ‘Prospect Theory: An Analysis of Decision under Risk’. Econometrica, March 1979.

• Jérôme Kerviel. L’engrenage, Mémoires d’un trader. Flammarion, 2010.

• Kimberly Krawiec. ‘Accounting for Greed: Unravelling the Rogue Trader Mystery’. Oregon Law Review, 2000.

• ———, ‘The Return of the Rogue’. Arizona Law Review, 2009.

• Nick Leeson. Rogue Trader: How I Brought Down Barings Bank and Shook the Financial World. Little, Brown, 1996.

• Roger Lowenstein. When Genius Failed: The Rise and Fall of Long-Term Capital Management. Random House, 2000.

• Charles Mackay. Extraordinary Popular Delusions and the Madness of Crowds. Broadway, 1995.

• Benedetto del Martino et al. ‘Frames, Biases and Rational Decision-Making in the Human Brain’. Science, 2006.

• PricewaterhouseCoopers. Investigation into Foreign Exchange Losses at the National Australia Bank. 2004.

• Promontory Financial Group and Wachtell, Lipton, Rosen & Katz. Report to the Boards of Directors of Allied Irish Banks, Allfirst Financial and Allfirst Bank Concerning Currency Losses. 2002.

• Barry Sinervo. ‘Optimal Foraging Theory: Constraints and Cognitive Processes’. University of Southern California Santa Cruz, 1997– 2006, available at printfu.org/ foraging + animals.

• Tobias Straumann. ‘The UBS Crisis in Historical Perspective’, Expert opinion prepared for delivery to UBS AG, 28 September 2010. University of Zurich.

• Nassim Nicholas Taleb. Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life. W. W. Norton, 2001.

• UBS. ‘Shareholder Report on UBS’s Write-downs’. 2008.

• Société Générale General Inspection Department. ‘Mission Green Summary Report’. May 2008.

• Andrew Weisman. ‘Informationless Investing and Hedge Fund Performance Measurement Bias’. Journal of Portfolio Management, Summer 2002.