Rogues of Wall Street

How to Manage Risk in the Cognitive Era

Andrew Waxman

• Publisher: Wiley
• Year: 2017
• Print ISBN: 9781119380146
• eBook ISBN: 9781119380153
• Edition: 1
• Topic: Business
• Subtopic: Financial Risk Management
• Index: Business

Reduce or prevent risk failure losses with new and emerging technologies

Rogues of Wall Street analyzes the recent risk failures and errors that have overwhelmed Wall Street for the past decade. Written by a veteran risk, compliance, and governance specialist, this book helps bank leaders and consultants identify the tools they need to effectively manage operational risk. Citing different types of risk events such as: Rogue and Insider Trading, cyber security, AML, the Mortgage Crisis, and other major events, chapters in the first half of the book detail each operational risk type along with its causative and contributing factors. The second half of the book takes an overarching approach to the tools and solutions available to financial institutions to manage such events in the future. From technology, to culture, to governance, and more, this book does more than simply identify the problem—it provides real-world solutions with actionable insight.

Expert discussion identifies the tools financial institutions have at their disposal, and how these tools can be leveraged to create an environment in which catastrophic events are prevented or mitigated. In-depth insight from an industry specialist provides thought-provoking guidance for leaders seeking more effective risk management, and specifically addresses how to:

• Analyze major operational risk incidents and their underlying causes
• Investigate the tools that allow organizations to prevent and mitigate catastrophic events
• Learn how culture and governance can be optimized to support effective risk management
• Identify ways in which cognitive technologies could help your firm avoid losses

Cognitive technologies have the potential to revolutionize the way business is done; eliminating the speed/cost/quality trade-off, these new and emerging tools are heralding the next leap in the evolution of risk management. Rogues of Wall Street shows you how bring these tools into your organization, and how they can contribute to your financial success.

CHAPTER 1
The Historical Context

Wall Street has changed immeasurably in the past several decades. Key changes that have occurred include computerization of trading, the growth of universal banks (and hedge funds), and the development of financial engineering. Each of these changes enabled major revolutions to take place in our larger society. Banks are not what they used to be, but while they were agents in enabling change in society—changes that brought major benefits—with these benefits also came major costs.

First, computerization of trading has helped to facilitate the growth of a shareholder society. The casual, retail investor now has access to trading tools that provide access to very liquid and fast‐moving markets with the ability to execute shorts, options, swaps, foreign exchange (FX), and other complex transactions from their PC or smart phone. The cost of participating in such trading activities has declined dramatically and, as a result, millions more people¹ own shares today than in the past. This has been in large part due to the creation of new trading and computer technologies and resulting cost reduction. Such gains are not achieved without risk, however. Some of the operational risk incidents we will review in the coming chapters stem from the technical challenges that are posed by such technological advances.

Second, the growth of universal banks² with massive capital resources and services aimed at every customer segment has helped achieve major efficiencies in the promotion of new capital structures and investment vehicles. The availability of credit to greater numbers of people and the provision of new types of financial innovation to every type of corporate entity has enabled the creation and expansion of new productive capacity in the United States. These advantages were particularly clear during the expansion years of the 1990s and early 2000s. However, these benefits also brought problems in their wake.

The sheer size of these universal banks and the stitching together of different legacy systems and bank cultures has created patchworks of manual process and controls that became too complex to manage. The risk of great and complex failures inherent in such unwieldy structures has, in the eyes of many analysts, grown, rather than retreated since the Financial Crisis of 2008. Most recently, Neel Kashkari, chief of the Federal Reserve Bank of Minneapolis, has argued for further controls to be put in place against banks that are so called “too big to fail.”³

To his point, managing multiple businesses and multiple country branches brings a level of complexity that makes it much more difficult to monitor activities across an entire organization. Additionally, privacy laws that have multiplied in different countries have further exacerbated this issue. This can and has led to failures to assert centralized controls and unified lines of defense against suspicious trading activity and the like.⁴

Third, the growth of financial engineering took place in the context of relatively light regulation and planning. Credit default swaps, for example, started as a relatively obscure product in an obscure trading group within investment banks. While investment banks and broker/dealers are required to oversee new product development in a careful way, new products have a habit of getting through with relatively little scrutiny and planning. This lack of planning is, in part, a reasonable response to the nature of the trading market. Many products are thought up in the twinkle of a trader's eye and many of them fail to take hold. In the case of credit default swaps,⁵ however, within a very short time frame, billions of them were being written to cover bondholders and non–bondholders. Expansion in areas like this brought much greater profits to the banks, at least for a time. It also brought much greater complexity to the business. Obscure products like credit default swaps can thus grow from a relative backwater status to a major profit center in a short space of time in a way that is hard to predict or plan for. The ability to manage the resulting complexity, however, does not tend to keep up. The rash of scandals, penalties, and significant operational losses in the case of mortgage‐securitized products are one indicator of that.

The rapid change at investment banks as a result of these particular areas of innovation has made it hard for regulators to keep up in their ability to understand and monitor these changes. Yet the role of regulators has never been more important. In some ways, the battle over regulation that took place in the years after the 2008 Financial Crisis, and in particular, the battle to introduce the Dodd‐Frank legislation was similar to that played out in the original battles fought by Washington and the SEC to establish US securities laws and the SEC in the 1930s. This will be discussed further in Chapter 22.

The battle fought by the regulators since 2008 has also been to arm themselves for battle more effectively, by adding to their ranks people with the expertise and experience to be able to identify, monitor, and manage the risks as they unfold at their charges' houses of operations. Unfortunately, it may always be the case that regulators, like the French generals of the 1930s who built the Maginot Line of Defense, are doomed to be forever fighting the previous war.

The example that perhaps best illustrates this is the case of Wells Fargo that hit the headlines in 2016.⁶ This was different from what had gone before in three important respects. First, relative to the mortgage and other scandals, which led to billions of dollars in lost wealth, the churning of unauthorized bank and other accounts involved sums that were relatively small. Second, instead of a few relatively high level traders being involved, as in, for example, the mortgage, FX and LIBOR scandals, this scandal involved thousands of fairly low level employees. Third, those involved in the scandal did not possess any special financial engineering skills, rather, they applied routine customer facing banking skills to set up and self‐authorize fake bank and credit card accounts. It is apparent that investment banks, faced with increasing regulation in the investment banking sphere, have been turning to retail and private banking as alternative sources of revenue. Even Goldman Sachs has established a unit for online personal banking so it may be that this Wells Fargo incident is the first of a new emerging class of risk. It is clear at least that the regulations and procedures put in place by compliance and risk management were not adequate to address this risk at Wells Fargo.

At the same time, it is also the case that banks have been able to put in place many sensible and effective controls to mitigate risks that they do run from their sheer size and complexity. Some of this has come about from the pressure that they have been put under by regulators. A friend of mine is an MD who works in an area called model risk at one of the major investment banks on Wall Street.⁷ Under the constant prodding of regulators and internal audit, he has constructed a complex set of controls over the various models used by the bank to value every single complex position that is traded there. If a trader is ever tempted to modify the way a position he is trading is valued, to perhaps help it reflect a profit to his greater advantage, it will be known straight away by those monitoring the valuation models. However, the separation of controls put in place most likely means that the trader, who in prior years would have been able to easily do such a thing, is now not able to do so. While this makes the bank safer than it was, there may be diminishing returns and unintended consequences from further nit picking by regulators with what has been accomplished.

Added regulations and administration has meant the need for banks to add significant resources to meet these regulatory requirements while hamstringing them in other ways. The ban or severe restriction on proprietary trading, the Volcker Rule⁸ for example, arguably has already had some negative consequences, even though the ban has only recently come into effect. One unintended consequence is that as banks have been adding to the ranks of staff engaged in compliance matters while they have been losing and shedding the trading talent that has been the long‐term source of their competitive advantage. Traders and risk managers have been leaving to join hedge funds, asset managers, and even insurance companies in droves. This drain on talent, has only added to the difficulties banks face in managing their trading risks effectively.

This is some of the context for the operational threats faced by the Banking and financial services industry today. Some of these are posed from the outside, some from the inside. What the banking industry cannot do is afford to let these threats subsist alongside their business model. Rather they have to address the issues head on. We will explore in the succeeding chapters how some of the changes described here have led to these threats and some of the tools that firms can leverage to address them successfully. We now turn our attention to some of these major events and losses.

Notes

1. According to the first shareowner census undertaken by the New York Stock Exchange (NYSE) in 1952, only 6.5 million Americans owned common stock (about 4.2 percent of the US population). By 1990, the NYSE census revealed that more than 51 million Americans owned stocks—more than 20 percent of the US population. 2. In the 1960s, finance's share of the GDP accounted for less than 5 percent of the US economy's output. By the 2000s, the proportion had risen to over 8 percent, fueled by a combination of middleman fees, for example, in asset management, and the credit explosion fueled by securitization (more of that later). The repeal of Glass‐Steagall enabled large banks to take advantage of these secular trends and bulk up through acquisition to provide services across the whole range of banking services, including retail, wholesale, asset management, treasury services, etc. Banking balance sheets of over $2 trillion came into being in the 2000s. 3. As interim Assistant Secretary of the Treasury for Financial Stability from October 2008 to May 2009, Neel Kashkari oversaw the Troubled Asset Relief Program (TARP) that was a major component of the US government's response to the financial crisis of 2007. Subsequently, as Chief of the Federal Reserve Bank of Minneapolis he has been an outspoken proponent of further reforms to manage risks posed by large banks. His most recent proposals made in November 2016 were covered widely by the press, including the article reference below: http://www.reuters.com/article/us‐usa‐fed‐kashkari‐idUSKBN13B1LD. 4. JP Morgan Chase agreed to pay $1.7 billion as part of a deferred prosecution agreement reached with the US Attorney's office for the Southern District of New York in January 2014 on charges that its failure to maintain an effective anti‐money laundering program helped to facilitate the multi‐billi...

Table of contents

• Cover
• Title Page
• Copyright
• Dedication
• Table of Contents
• Introduction: A Risky Business
• Acknowledgments
• About the Author
• Chapter 1: The Historical Context
• Chapter 2: The Rogue Trader
• Chapter 3: Genius Traders: Who They Are and How to Catch Them
• Chapter 4: Insider Trading
• Chapter 5: Price Manipulation Risk: The Big Unknown
• Chapter 6: The Mortgage Mess
• Chapter 7: Ponzi Schemes and Snake Oil Salesmen
• Chapter 8: Rogue Computer
• Chapter 9: Funding the Bad Guys—Winning the AML Battle
• Chapter 10: Litigation and Big Data Risk
• Chapter 11: Twitter Risk and Fake News Risk
• Chapter 12: Spreadsheet Risk: Should We Ban Excel?
• Chapter 13: Acts of God Risk
• Chapter 14: Cybersecurity—The Threat from Outside and Inside the Firewall
• Chapter 15: Turning the Tables on Risk
• Chapter 16: Building the Right Culture: Values, Organization, and Culture
• Chapter 17: The 360‐Degree Risk Management Function
• Chapter 18: What We Talk about When We Talk about Risk
• Chapter 19: The Future Is Unknowable, the Present Burdensome; Only the Past Can Be Understood
• Chapter 20: The New Tools of the Trade
• Chapter 21: Cognitive Technologies
• Chapter 22: The Role of Government and Regulators in Managing Risk
• Chapter 23: Case Studies and Guiding Principles in Planning for Disaster
• Chapter 24: The Risk Management Society and Its Friends
• Chapter 25: Conclusion: Seven Traits for Successfully Managing Cognitive Risk
• Index
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