The risk control myth that cost $2 billion at UBS

Bob Wolf discusses the characteristics common to failures like that of the rogue trader at UBS.

by Bob Wolf, SOA Staff Fellow, Risk Management

BobWolf In a seminal book on comparative mythology, The Hero with a Thousand Faces, author Joseph Campbell argues that the stories that provide the basis for most major religions and ethnic pride share similar fundamental structures and symbols. After reading the details of the $2.3 billion loss at UBS AG by trader Kweku Adoboli, I am reminded of glimpses of the past.

Let’s call this particular financial services mythology – “The Controls with a Thousand Blind Eyes.” While a tiny hyperbolic, this title hopefully gets across the point that in the case of Mr. Adoboli, as well as the cases of Jerome Kerviel (loss of more than $7 billion in 2008 at Societe Generale) and Nick Leeson (collapse of Barings Bank) there were a number of similar characteristics. Those of us at the Society of Actuaries (SOA) have been studying these cases for a number of years. In so doing, we have found a number of similarities.

Most notably, these similar characteristics were discussed in a panel session at the 2009 SOA Annual Meeting, the largest conference for dedicated to the actuarial sciences, and remain prevalent in the situation UBS finds itself in today. During a session entitled “A Case Study of Case Studies,” the panel summarized an informal study on the four themes that seem to emerge as common denominators in virtually all of these types of failures, including the colossal failures of recent times (Enron, WorldCom, etc.). The study was sponsored by the SOA/CAS/CIA Joint Risk Management Section, a cross-disciplinary group of actuaries. They concluded that the common characteristics of these types of situations include:

1. Business model failure –This is the failure of developing and carrying through on sound strategic planning that allows the firm to survive and thrive in a highly competitive environment. As actuaries, we all are fans of models, the scientific method and comprehensive risk management systems. With that said, we also have a deep appreciation for the human element in risk. Managers of traders are as important as software that detects aberrations in trading patterns. The point is that accountability is an integral part of effective risk management.

2. Lack of proper risk metrics in place in analyzing the true element of risks undertaken to achieve com­pany goals – This is consistent with the lessons learned from the financial cri­sis in which incentive compensation schemes were not appropriately tied to the desired performance of com­pany executives. In other words, there were no general controls in place to contain excessive risk taking in trying to achieve company goals. In some cases, where there were considerations of risk metrics, they were not prudently in place. In some cases no risk metrics were even considered.

3. Lack of a truly independent inter­nal audit function – This lack of true independence has harmed the ability of firms to prevent traders, as is the case with UBS, or execu­tives from harming the company for individualist opportunity or gain. Similarly, and consistent with the lessons learned from the financial cri­sis, there are many instances where the authority to make decisions did not tie to accountability for decisions made. The Chartered Institute of Internal Auditors recently released a survey showing 63 percent of organizations failed to have any independent review of the findings of the internal teams. We have an industry-wide problem of both “turning a blind eye” and failing to get enough eyes on risk management, people, processes and technology.

4. Inadequate asset/liability management: In essence this translates to using short-term assets to fund long-term obligations, result­ing in higher long-term liquidity risk. Clearly asset/liability management is a prudent discipline needed both in and beyond the financial services sector.

Over the next few weeks, we can expect a steady drumbeat of news about new controls at UBS. They will probably be similar to those put in place by Societe Generale in 2008. While these steps will start the slow, long process of improving the perception of risk management systems at UBS, we should not take this to be the end of the story.

I just saw a glimpse of the past. Is this just a blip? Or..have the industry norms for a prudent enterprise risk management discipline in the banking industry evolved enough? Or at all?

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One response to "The risk control myth that cost $2 billion at UBS"

  • Mary Pat Campbell says:

    I’ve just been reading The Big Short by Michael Lewis, which also has some interesting lessons in risk and risk management.

    Lewis focuses on the humans particularly in the story, and I’m sure he exaggerated some of the situations… but probably not by much. In many of these cases, you had people unable to understand the risks (and it is very difficult to get people to admit they don’t understand things, especially if it’s supposed to be their job that they do) and even worse, there were people who did not want to understand the risks.

    It’s nice to talk about technical expertise and systems, but when the good times are rolling, it’s only the weirdos who are yelling at others to stop and that it’s dangerous. The men who yelled this during the CDO run up were ridiculed, though there’s a happy ending for many of them as they made money off the stupidity of others. But lots of people got ruined as well.

    It is extremely difficult to make people accept the discipline of controls. Controls are loosened right at the time when they should be strengthened, because no one wants to stop the party.

    As someone else remarked – you only hear of the unauthorized losses, you never hear of the unauthorized gains.

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