Headlines blazed in 2011 with stories about settlements and losses resulting from the credit crisis. But it wasn’t foreclosures and subprime issues that cost the banks the most money in the year past. It was an old bugaboo: the rogue trader.
How it Happened
The weakest point in many large financial institutions is the controls known as trading limits. Banks lost billions of dollars as traders once again discovered ways to subvert limits by creating fake offsetting trades. Many banks have fallen and almost all institutions have struggled as a result of the recent financial crisis, but for those with short memories, rogue traders have the ability to bring down an institution virtually overnight as we saw in the late ‘90s with Barings.
Proprietary trading desks are tasked with making money and are often given wide latitude in how they achieve that end. Positions taken by traders can be extremely large. By creating phantom trades to offset the underlying positions traders can avoid taking a loss and continue trading. Losses spiral and by the time the rogue trader comes forward to admit what he had done the entire bank can be underwater based on the losses of a single trader.
Management on the Hook?
If management failures are found to be responsible for a rogue trader’s losses, a bank could face lawsuits from investors. Many of the past rogue trader losses, like Barings and Societe Generale, have resulted in shareholder suits against management.
Any claims against management will likely be in part or whole covered by the bank’s D&O and E&O insurance. However, the availability of rogue trader insurance is extremely limited and banks rarely carry enough cover to deal with the potential mega-losses that we have seen in the past.
For this reason rogue trading events have a double impact – an uncovered trading loss and possible suits against management for failing to prevent the unauthorized trading.