In this report, different types of risk and management techniques are analysed. However, the main focus is operational risk. The Basel agreements are analysed to show their effectiveness in decreasing operational risk. The Capital Asset Pricing Model and The Modern Portfolio Theory are also used to show how bankers attempt to mitigate risk by diversification. The concept of duration, interest-sensitive gap management and hedging tools are mentioned to demonstrate methods of interest rate risk management. This report analyses the operational risk cases of UBS, Herstatt, Barings and Société Générale. The differences and similarities of these cases are discussed. The report then draws conclusions what has been learned and what can be done to attempt to avoid rogue trading.
With the rise of risk exposure in financial institutions and the horrific consequences of operational risk, it is important to identify why rogue trading occurs and how risk management is necessary to avoid such disasters. This report aims to analyse existing methods of risk management in investment banking and suggests other approaches that financial firms can take. There are tools that can be used to reduce market and credit risk such as the duration gap and the interest-sensitive gap, however there is not any specific tool that can prevent operational risk. Nevertheless, regulators have attempted to mitigate operational risk with the development of the Basel agreements by making it a requirement for financial institutions to hold high levels of capital in the event of operational risk situations. Operational risk cases have arisen in financial institutions such as UBS, Barings, Herstatt and Société Générale. It is important to analyse how and why rogue trading occurred and what has been learned in these instances. Risk management is an integral part of any financial institution and requires considerable attention in order to avoid rogue trading in particular.
Rogue trading can cause profound losses for a bank, and although it doesn’t occur frequently, when it does, it can lead to an eternally damaged reputation or even closure. UBS has prevented closure, but it has led once more to a loss of confidence in a financial institution that has regained credit since it almost collapsed as a result of losses on toxic assets. Rogue trading is an example of operational risk which can be defined as the risk arising from a financial firm’s functions, due to misconduct by employees, natural disasters, failures in computer systems and other similar factors.
Banks and regulatory bodies have devoted a large proportion of resources to managing market and credit risk, nevertheless, the intricacy overshadowing a financial institution’s activity and technology, has deemed it necessary for operational risk (particularly the risk of financial fraud) to be focused on by both managers and regulators, in order to mitigate the risk. The complexity of new financial instruments and products renders it difficult for clients and even bankers themselves to understand how they work. This lack of understanding and unfamiliarity is also expressed by regulating bodies and consequently, they have struggled to develop a method of frugal management for these elaborate activities. Although the modernisation of banking has created the opportunity for more cases of operational risk, it should not be ignored that it is was much of a problem in traditional banking as it is in modern banking.
The relationship between risk and return is one to which bankers may not pay much attention as they are usually inclined to achieving high returns and profit. What they fail to consider are the risks associated with achieving these goals, which some accept without qualms. Although there are no specific tools to manage operational risk, bankers can use tools to manage other types of risk such as market, credit and interest rate risk. Such tools such include the interest-sensitive gap, which helps to identify how much a financial institution can be exposed to interest rate risk and Duration techniques, which are used to reach a desired gap between the duration of assets and the duration of liabilities. They also use a short hedge in futures to hedge against expected rises in interest rates and a long hedge for expected falls in interest rates.
Bankers use methods to calculate the required return on an asset such as the Capital Asset Pricing Model (CAPM), but what they overlook are the operational risk factors which could affect the return on an asset. Geographic diversification is also a way of reducing risk, as customers located in different countries are assumed to be exposed to different economic conditions and therefore, cash flows from an economically stable international market may offset declines in cash flows from other international customers, which may have experienced exogenous shocks. The Modern Portfolio Theory (MPT) supports the idea of diversification in order to maximise expected returns against a given level of risk. A favoured method to measure the performance of a portfolio would be the Sharpe ratio which takes into account the return and reward per unit of risk. There are downfalls of the CAPM and MPT theories, as they assume that bankers are risk averse and act rationally. While this assumption may be justified in certain scenarios, it does not comply with the irrational actions of rogue traders; therefore other methods of risk management must be identified to limit operational risk.
The first Basel agreement, which was adopted in 1988, was a regulatory attempt to mitigate risk; however, the agreement focused on credit and market risk alone. The Basel II agreement which was implemented in July 2008, allows for other types of risk to be considered, particularly operational risk. According to pillar two of Basel II, banks are required to hold capital to deal with operational risk situations should they arise. This requirement was deemed to be an innovative step in Basel II, which may be of great significance as UBS did not collapse as a result of adhering to the Basel II regulations, by holding high levels of internal capital. Despite the survival of UBS, it is still necessary to completely mitigate rogue trading.