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Appendix: Answers to Review Questions

CHAPTER 1

1.c
2.a

CHAPTER 2

1.a
2.d

CHAPTER 3

1.c
2.b

CHAPTER 4

1.b
2.b

CHAPTER 5

CHAPTER 6

CHAPTER 7

1.c
2.b

3.e

4.d

CHAPTER 8

CHAPTER 9

CHAPTER 10

CHAPTER 11

1.c
2.a

CHAPTER 12

1.a
2.d

CHAPTER 13

CHAPTER 14

CHAPTER 15

CHAPTER 16

CHAPTER 17

CHAPTER 18

Case 1

IBM FIRST classified the event as outlined in Table A.1:

TABLE A.1 IBM First Classification of Archegos Credit Suisse Event

Keywords Indexing
Entity Type	Financial Services/Banking/Commercial/Full Service Bank
Business Unit Type	Trading and Sales (BIS)/Trading
Service/Product Offering Type	Derivatives, Structured Products and Commodities/Derivative Products/Over-the-Counter Derivatives
Contributory/Control Factors	Corporate/Market Conditions/Corporate and Market Conditions Lack of Control/Failure to Disclose Lack of Control/Lack of Internal Controls Management Action/Inaction/Poor Judgment Management Action/Inaction/Undertook Excessive Risks Omissions/Inadequate Due Diligence Efforts Organizational Structure/Inadequate Organizational Structures
Loss Type	Known
Loss Impact	Direct Loss/Write-Down (BIS)/Write-Downs Indirect Loss/Income Indirect Loss/Management Remediation Indirect Loss/Reputational (Non-Monetary) Indirect Loss/Revenue Indirect Loss/Share Price
Loss Detection Sources	Whistle Blowing/Counterparty Originated
Market Focus	Institutional Services
Event Trigger	Process Risk Class/Transactional and Business Process Risk/Lack of Proper Due Diligence
Basel Levels I and II	Execution Delivery and Process Management/Transaction Capture, Execution, and Maintenance/Collateral management failure
Basel Business Line	Trading and Sales/Proprietary Positions

IBM FIRST outlined the following lessons learned:

Lessons Learned

The Wall Street Journal (April 1, 2021) noted that in July 2020 Credit Suisse had reorganized, “combining risk and compliance and creating a committee to look specifically at big clients. The changes were also described as having ‘significant efficiency potential’ and cost savings.” The merits of such a “cost-saving” combination were under reassessment in early April 2021, as the Credit Suisse announced that former general counsel Thomas Grotzer to be the bank’s new global head of compliance.

The huge losses incurred by some banks’ prime broker units suggest that banks need to do a better job of managing collateral when managing credit extended to certain wealthy investors and small firms. In this case, it appears that the banks had very little understanding of the risks they were exposed to when they entered into swap contracts with Mr. Hwang or his firm—and were in the dark as to what other obligations their client faced with other brokers.

Regulators are likely to investigate the whether there were risk management failures at the various prime broker units, the extent to which derivatives contracts (such as total return swaps) were adequately secured by collateral, and whether the institutions faced any potential conflicts of interest. For example, the SEC might be possibly looking into whether Morgan Stanley faced any conflict of interest if it was acting as underwriter of ViacomCBS's share offering if it also was counterparty in some of Archegos’ swaps contracts. The scope of disclosures by family firms may also be up for review.¹

Case 2

ORC classified the event as outlined in Table A.2.
Regulatory action for anti–money laundering (AML) breaches is generally very severe and can include fines, consent orders, and requirements to restrict business growth until remediations are complete. A Google search of AML regulatory consent orders in the United States will provide further context for discussion.
Consider the impact of culture, controls, and risk management in the failings that contributed to this event.

TABLE A.2 ORX Classification of DNB Bank ASA Event

ORX Reference Taxonomy Level 2 RT1004 – KYC and transaction monitoring control failure
Boundary Risk Other Risk	Industry Event	Scenario SC0006 – AML Failures
Product PD0603 – Commercial Bank Accounts	Process PC0401 – (New) Client Account	Event Closed No
ORX Member No	Role of Firm LS0307 – Position Taking (Principal)	Jurisdiction/Choice of Law LS0105 – Western Europe (excluding United Kingdom)
Cause 1 CS0303 – Financial Reporting	Cause 2 CS0403 – Inadequate Policy/Procedure	Cause 3
Counterparty LS0211 – Regulator	Environmental Volatility LS0406 – Not Identifiable	Provision No

Case 4

IBM FIRST provided the following suggested lessons learned; many are repeats of exactly the same control failings that were identified in the Société Générale event:

Lessons Learned

The Wall Street Journal on September 16, 2011 said that banks seeking to detect unauthorized trading should supplement their routine electronic surveillance with “an older method of detection: looking out for suspicious behavior.” Echoing some findings of the Societe Generale investigation, the WSJ cited several red flags: “traders not taking vacations; traders having a lot of cancelled or amended trades; traders working out of business hours or logging fewer hours on recorded lines; and traders whose trades are questioned by counterparties or exchanges.” The size of the loss in this case certainly poses a reputational risk to UBS. In the words of a Financial Times (September 15, 2011) report, “Hard questions need to be asked about UBS’ internal risk controls. It’s hard to believe the Swiss bank’s view that it cannot identify the area in which the rogue trades were made, or when more information might become available—everything has an electronic audit trail.”

The loss amount ($2.3 billion) is the largest rogue trading loss ever by a Swiss bank and the third-largest unauthorized trading loss on record, exceeded only by the January 2008 Societe Generale loss of $6.8 billion (Event #7945) and the 1996 Sumitomo Corporation loss of $2.8 billion (Event #1699). These and other cases can be found using the Unauthorized Trading keyword.

Nor is this the first time that the London offices of UBS have suffered from unauthorized trading. In November 2009, the FSA fined UBS GBP 8 million ($13.3 million)—one of the FSA's biggest fines ever—for weak controls that allowed staff to make as many as 50 unauthorized trades a day on at least 39 client accounts and then conceal the losses. (see Event #9481)

The Wall Street Journal reported on September 22, 2011, that the FSA was looking into several possible rogue trading cases at other institutions in London. “At least three of those cases involve traders who previously had worked in the bank’s ‘back-offices’ where employees enter and confirm trades, handle accounting issues and transmit payments,” the paper said. After the Societe Generale fraud, some banks reportedly began asking supervisors of traders who come from a “back-office” background to enhance their supervision. Since the FSA does not have sufficient staff to monitor trades at large banks however, it is incumbent on banks to be aware of risky trades before large losses are found to have occurred. Traders exceeding their risk limits can (at least in theory) return profits, so banks should pay attention to unexpectedly large profits before they are surprised by unexpectedly large losses.

One of the key questions to be answered by any investigation is how such a large unauthorized trading loss on the “Delta One” desk went undetected, especially after the highly-publicized Societe Generale fraud. Since it appears that Mr. Adoboli's losses were in market index futures (as was the case with trades executed by Jerome Kerviel) it is as yet unclear why his fictitious hedging positions went unchecked. At the very least banks should require confirmations of ETF trades by counterparties.

At least one online analyst, Paul Amery, argues that lax operational settlement procedures for bank-traded ETFs could prove to be a major factor. Firstly, in London the late settlement of ETF transactions is not unusual and is not subject to major sanctions. Secondly, many counterparties do not request trade confirmations, especially for OTC transactions. Mr. Amery concludes: “Taken together, these two loopholes may have enabled the creation of fake transactions in UBS's systems. Even if this was the immediate cause of the fraud, the bank's risk controllers seem to have missed other warning signs. High gross trading positions, even if the trader reported his position as hedged, plus what were presumably significant cash outflows in margin as the result of losing futures positions, might together have been expected to flag that something was wrong.”

The Financial Times reporter Gillian Tett noted that trading in ETFs requires yet more attention from regulators, since sales of ETFs—which have been very profitable for banks—could pose conflict-of-interest problems if banks were acting as counterparties in the same funds they sold to customers.

A few weeks before it disclosed the loss, UBS had announced a plan for 3,500 layoffs—a 5 percent cut in its global work force—half of them in the investment banking arm, in order to meet tougher economic conditions. Press reports said that the loss would also lead to calls from investors and legislators for Swiss banks to reduce their investment banking activities and focus more on private banking and fund management. Regulators could ask for even more stringent capital requirements for investment banking activities, or seek to protect client business from risky proprietary trading.

The Swiss parliament was discussing measures to improve the safety of the biggest Swiss banks (UBS and Credit Suisse) even as the event was disclosed. The “too big-to-fail” banks earlier got taxpayer bailouts after losing large amounts investing in mortgage-backed securities from 2006 to 2008. A representative of the Swiss People's Party (SPP) told Bloomberg News: “There can't be another state bailout. It can't be up to the state and taxpayers to rescue large banks that are involved in risky business.” Another SPP member found yet another lesson: “It shows that investment banking is a high-risk field and it's important that we clearly separate systemically important functions from the rest of the banking business.” Such concerns have also been echoed elsewhere.

The proposal to “ring-fence” bank activities on their customers’ behalf from risky bets in proprietary trading was a feature both of the Volcker rule (enacted as part of the Dodd Frank Act) in the United States, as well as the recent Vickers Report (available here) into banking in the United Kingdom. Proponents of stricter banking regulation in these and other countries will likely to point to the UBS case to bolster their argument. As Martin Wolf, a columnist for the Financial Times wrote: “Thank you UBS … I could not have asked for a better illustration of the unregulatable risks to which investment banks are exposed.”

In what may be an emerging trend, the Swiss regulator FINMA noted in its summary report that outsourcing of control functions to India was a contributing factor in UBS’ failure to detect unauthorized trading. Such outsourcing has also been mentioned in another high-profile case. In August 2012, the New York Department of Financial Services accused Standard Chartered of involvement in laundering financial transactions (11885). The regulator said the bank's compliance function had been moved to Chennai. The New York regulator cited “no evidence of any oversight or communication between the Chennai and the New York offices” with regard to Standard Chartered's compliance with regulations issued by the Office of Foreign Assets Control (OFAC).²

NOTES

1 FIRST Report for Loss Event 19072/OpData ID 23123.
2 FIRST Report for Loss Event 11117/OpData ID 15887.

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Table of Contents for Appendix: Answers to Review Questions

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