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Like a Hollywood studio’s ill-conceived idea for a sequel, UBS’s recent $2 billion unauthorized trading loss conjures the working title: Risk Management Failure, Part 2. The Swiss bank took a $50 billion loss on subprime mortgage securities in the midst of the financial crisis and had to face the music again this week. On Thursday came news that an unidentified “rogue trader,” or traders, in their London office has cost UBS $2 billion. So far, only one person, 31-year-old trader Kweku Adoboli, has been arrested in the matter. After the subprime disaster four years ago, top management at UBS was called to task for having a Pollyanna-ish view of their risk exposure, the Financial Times reports. And now, as then, the rogue-trading fallout is raising questions about the bank’s risk management systems. “I think the real problem is the complexity of an organization,” says legal scholar Jerry Markham, author of A Financial History of the United States and former counsel at the Chicago Board Options Exchange Inc. and the division of enforcement at the U.S. Commodity Futures Trading Commission. If individuals are compelled to manipulate the books or cover up what they’re doing, those actions obscure the picture for risk managers, says Markham. Periodically, he adds, someone is always bound to test their luck against the existing controls. Take the case of Nick Leeson, whose $1.4 billion loss is considered small in the trader rogue’s gallery—yet his fiscal malfeasance sank Barings Bank entirely in 1995. Leeson’s escapades offered, at the time, a case study in risk management and spurred the Futures Industry Association to launch a global task force on these issues. “No one really knew what he was doing,” says Markham. Leeson lost money in an area he was supervising, triggering a circular, destructive pattern of covering his losses with unauthorized trades. “It got out of control,” says Markham. One factor in risk control is a company’s incentive structure—what are the rewards for a win, versus the consequence for a loss. But the key to internal risk control, says Markham, is “you need to have a separation of functions.” For example, if someone enters a trade, that order ticket should have to be processed by an entirely separate department. Risk control systems are often proprietary, but a typical risk control system is layered, Markham explains. At the level of the trader, there would be limits on products and amounts they can trade. A monitor would exist above the trader. And then there would be a risk control system monitoring trading overall—and investigating if a unit is losing or profiting too much. Media reports on the UBS rogue trading incident are asking whether lessons were heeded from similar scandals of the past, and whether there are more deep-seated problems at UBS. There are some cases of major failures that led to implementation of risk management safeguards. After derivatives trader Jerome Kerviel lost $6.7 billion in unauthorized trades at Societe Generale in 2008, the U.K. Financial Services Authority discussed the case with approximately 50 banks in London, Bloomberg reports. According to a March 2008 policy document, many of those banks “had already put in place reviews to ensure they identify any gaps in trading controls and close them as soon as possible.” Financial Times blogger and chief business commentator John Gapper maintains that, “given the recent history of UBS, it is fair to ask if Kweku Adoboli is a rogue trader or his employer is a rogue bank.” Gapper cites a UBS-commissioned report, post-subprime crisis, by the University of Zurich’s Tobias Straussman “that was scathing about [UBS's] ability to control risk and the complacency of its senior management.” The report found that: Top management was too complacent, wrongly believing that everything was under control, given that numerous risk reports, internal audits and external reviews almost always ended in a positive conclusion. The bank did not lack risk consciousness; it lacked healthy mistrust, independent judgment and strength of leadership. Only at the beginning of this year did Maureen Miskovic take over as UBS’s chief risk officer. “She arrived from U.S.-based financial services group State Street with a strong reputation and has shaken up risk management at the bank, according to one industry source,” Reuters reports. Markham expects that the rogue trading incident will prompt calls for restrictions on proprietary trading—even though, he believes, a bank’s interest in self-preservation is more effective. “It’s really in their own interest to protect themselves. Regulations don’t add much to the quotient.” And who would even be doing the regulating in this specific case? The Wall Street Journal notes that because of the way UBS operations arestructured in Switzerland and London, it remains unclear whether Swiss or U.K. regulators are responsible for the unit where the man who was arrested worked.

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