FRM Level 1 | Financial Disasters
Chase Manhattan Bank & Drysdale Securities
Drysdale borrow $300M unsecured funds on capital of $20 million . Made
investments in bonds; value eventually declined. Unable to repay borrowings;
forced into Bankruptcy. Chase has brokered these borrowings and hence had
to absorb losses.
How did it happen?
➢ Chase failed to detect the unauthorized position; did not believe that the
firm’s capital was at risk.
➢ Inexperienced managers of Chase did not correctly interpret borrowing
agreements that made chase responsive for payments due.
➢ Drysdale exploited a flaw in computing value of collateral (collateral valued
without considering accrued interest)
➢ Chase did not notice in the contract that it would be held responsible for
any payments due.
Lesson learned
➢ Develop accurate methods for evaluating value of collateral
➢ Seek the approval of risk control function when issuing funds.
Sumitomo
Yasuo Hamanaka attempted to corner the copper market in a classic market
manipulation strategy.
How did it happen ?
➢ Yasuo established a dominant long position in futures and simultaneously
purchased large quantities of physical copper.
➢ As delivery approached, the party with the short position would find little
physical copper available for delivery and would be forced to either pay a
large premium for physical copper or unwind its short position.
➢ Severe losses would be unavoidable if copper prices fell.
➢ Low degree of supervision and broad powers allowed Hamanka to
implement his fraudulent trading strategies without detection.
➢ This created a high degree of operational risk, which could have been
reduced by strong internal control.
➢ Lack of supervision allowed Hanamaka to keep two sets of trading books,
one of which reported large profits , other set recorded huge losses and
was secret.
Lessons learned
➢ Internal control and supervision should be strong
➢ Large transactions should have multiple approvals by senior management.
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Barings
Nick Leeson, a junior trader, took speculative derivative position in order
recoup prior trading losses, which eventually resulted into more losses. Total
losses of $1.2 Billion.
How did it happen?
➢ Nick used two strategies – sold straddles on the Nikkei 225 and
arbitraging price differences on Nikkei 225 futures contracts
➢ Earthquake hit Japan, Nikkei plunged, creating huge losses on these
strategies.
➢ Lesson was in charge of settlements operations which allowed him to
influence back office employees to hide his trading losses
➢ Lesson was responsible for reporting to multiple managers in a
convoluted organizational structure, this situation created ambiguity.
➢ Baring lacked risk management oversight, that would have monitored
positions, strategies and risk.
Lesson learned
➢ Need to separate the control groups from trading groups
➢ Regulators across the world also became aware of risk management.
Allied Irish Bank
John Rusnak hid $691M losses from management by bullying back office
employees into not following-up on trade confirmations for imaginary
trades. He used his dominant personality to manipulate back office function
and avoided reporting of fake covered trade.
How did it happen?
➢ John Rusnak hid losses from management.
➢ He made strategies look less risky
➢ These strategies involved very large currency positions.
➢ He was able to hide these trading activities from management by
creating fake trades to offset his real trades.
➢ He made a point of reporting only modest gains so to not raise red flags.
➢ He disguised his actions from management by entering false positions in
the firm’s system for calculating risk measures such as value at risk (VaR)
Conclusion
➢ AIB’s management was inexperienced and was unable to figure out
Rusnak’s trading activates
➢ Suspicions trades were ignored by the management.
FRM Level 1 | Financial Disasters
Banker’s Trust
Procter & Gamble (P&G) and Gibson greetings sought the assistance of Bankers
Trust (BT) to help them reduce finding costs, BT used derivative trades which
promised the two companies a high probability small reduction in funding costs
in exchange for a low- probability, large loss. Unfortunately these trades
resulted is significant losses.
How did it happen?
➢ Derivative structures was intentionally made complex to prevent P&G and
Gibson from fully understanding the trade values and risks that were
involved.
➢ The structures were not comparable to other company derivative trades
making it impossible to get a competitive quote.
➢ P&G and Gibson were misled into thinking that the structures were tailored
to meet their individual needs
➢ They realized that they had been misled after discovering that they had
suffered huge losses. As a result, the two companies sued BT. Bankers Trust
scandal severely damaged its reputation and forced its CEO to resign
Lesson learned
➢ The importance of matching trades with a client’s needs and providing price
quotes that are independent from the front office.
➢ The importance of exercising caution with any form of communication that
could eventually be made public.
Kidder Peabody
Joseph Jett misreported gain of $350M. This event did not result in actual loss
to the company but triggered a loss of confidence in the management of KP
How did it happen?
➢ Joseph Jett, misreported a series of trades which allowed him to report
substantial artificial profits.
➢ Jett was able to report profits since the computer system used to report
government bond trading activity did not account for a forward contract’s
present value.
Lesson learned
➢ Importance of investing large profits from unknown trading strategies.
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Societe Generale
Societe Generale’s junior traders, Jerome Kerviel, was involved in
unauthorized trading activity that resulted in losses of $7.1 billion. The
incident damaged the reputation of Societe Generale and required the bank
to raise additional funds to meet capital needs.
How did it happen ?
➢ Jerome Kerviel created fake transaction to hide the size and riskiness of
his unauthorized positions.
➢ Kerviel used his knowledge of control personnel confirming timing to
cancel the trade right before any confirmations took place
➢ Given the need to continuously replace fake trades with new ones, he
created close to 1,000 fictitious trades
➢ Incorrect handling of trade cancellations, lack of proper supervision, and
inability of bank’s trading system to consider gross positions led to this.
➢ The system was not set up to flag any unusual levels of trade
cancellations; banks systems was only set up to evaluate net positions
instead of both net and gross positions.
➢ Reason - Weak reporting system for collateral and cash accounts and the
lack of investigation into unexpected reported trading gains.
Lesson learned
➢ Traders who perform large amount of trade cancellations should be
flagged.
➢ Tighter controls in situations involving new or temporary managers.
➢ Control personnel should not assume the independence of trading
assistant’s action.
➢ Mandatory vacation rules should be enforced.
➢ Requirements for collateral and cash reports must be monitored
➢ Profit and loss activity that is outside reasonable expectations must be
investigated.
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