There are no rogue traders, there are only rogue banks

This is my Sunday Washington Post column from last weekend:

There are no rogue traders, there are only rogue banks

In 1995, derivatives broker Nick Leeson of Barings Bank engaged in “unauthorized” speculative trading. The massive losses — 827 million pounds — led to the collapse of Barings, the oldest investment house in Britain.

In 1996, another rogue, Sumitomo Bank copper trader Yasuo Hamanaka, lost at least $1.8 billion. Some reports put the true losses at $4 billion.

Then, in 2008, Jerome Kerviel of Societe Generale lost 4.9 billion euros — about $6.8 billion.

And just last week, UBS suffered a $2.3 billion hit connected to an alleged rogue trader.

As history teaches us, there are no rogue traders; there are only rogue banks.

Here’s a news flash: If you issue credit, your working assumption must be that there are unqualified people who will try to borrow money from you. It is the job of every lending facility each and every day to separate the qualified borrower who has the capacity to service that debt from the unqualified borrowers who do not. This is why there is no such thing as a predatory borrower — banks must assume that all borrowers are predatory and protect themselves. This is why lenders — at least before 2002 – inquire about income, employment history, credit scores, other debt, etc., before making a mortgage loan.

Similarly, if your business involves the use of leveraged capital for speculation by your employees, then it is your job to know which, if any, of your people are not competent. It’s a simple mathematical fact that some of your traders will take losses; in some cases, enormous but manageable losses. Your job is to identify these people and move them to other professions.

There will be a small number who will try to hide their inabilities. Your job is to separate the qualified from the unqualified, to watch over the full lot of traders and speculators in your employ. Toward that end, you will establish trading limitations, leverage constraints, risk parameters. Traders must stay within the limitations you impose on them: money lines, maximum drawdowns, loss limits.

Thus firms that highly leverage their capital to put it into the hands of a few thousand employee speculators have a crucial job: They must ensure that capital is being precisely and properly managed. They must make sure that risk levels are tolerable, that proper controls are in place, that their IT systems and internal technology can track what is happening, in as near to real time as possible.

This is not easy. It is a complex set of processes that requires constant vigilance. It must be reflected in the corporate culture from the top down. And it becomes more and more complex as the size of the organization grows. The assumption must be that every employee is a potential rogue trader.

Banks are supposed to have expertise in preserving capital and managing risk. If they cannot discharge those simple duties, then perhaps they should not be in the business of finance. Most of all, they should not be engaging in behavior that puts taxpayer money at risk.

Anyone who runs a shop that has a proprietary trading desk is obligated to do everything in his power to prevent that single employee from bringing down the company. It’s not too hard to see that anyone who earns a bonus by risking the firm’s capital is a potential disaster.

With this backdrop, how is it that we seem to have a major rogue trader pop up every year or so? The simple answer is, a rogue trader who nets massive losses is a complete and utter failure by the bank’s management. UBS was unable to track its capital on a timely basis, as its London trader hid losses for more than three years. So much for real-time supervisory tracking.

The arrest of a rogue trader is a red flag. The discovery of the fraud is a company admission of being poorly managed. The board of directors should be holding senior management just as responsible as the trader for the losses. They may not have committed the same legal fraud — hiding the trades — but they should be sacked for gross dereliction of duty.

Understand what this means within the broader context of our financial sector’s not so innocent foibles: Any firm that hires “robo-signers” is just as bad as a firm that has rogue traders. Both actions are an indictment, an admission of failure and of managerial incompetence. Each illegal act represents a crucial failure of risk management, of legal compliance, of the ability to do jobs safely and within the law.

In an era of bailouts on the backs of the taxpayer, it points to a simple reality: Firms must decide whether they are going to sacrifice profit in pursuit of safety, or sacrifice safety in pursuit of profit. Whatever they decide, it is not the responsibility or obligation of taxpayers to backstop these choices.

Consider the choices made by management: The collapse of firms such as AIG, Bear Stearns and Lehman Brothers were caused by the same sort of poor judgment as UBS’s $2 billion in losses — only the rogues gallery there included the senior-most managers of the firms. Alan Greenberg exhorting his staff to focus on reusing paper clips, while the mortgage syndication division lost billions of dollars. Dick Fuld surrounding himself with yes men while the firm’s leverage and risk exposure went through the roof. Tom Savage, president of AIG’s Financial Products, calling derivative underwriting free money.

Paul Volcker, arguably the greatest central banker in history, has persuasively argued that proprietary trading should not be part of the insured depository banking sector. I utterly agree with Fed governor Thomas Hoenig, who has described the banking sector as “more akin to public utilities” than independent entities. Want to be independent to pursue proprietary trading? Let’s drop their FDIC insurance and see how far their reputations carry them.

The next crisis — the one after the present one in Europe — is where I expect to see the ultimate damage wreaked by rogue bankers.

The bailouts have created a moral hazard, where leveraged speculators and rogue bankers know that the state will bail them out. This is unacceptable. There is no reason that taxpayers should be responsible for any rogues, traders or bankers.

Perhaps UBS’s failure to prevent this did us a favor. It points out that Volcker is right: Any firm that can blow itself up should not qualify for taxpayer guarantees. Lenders, underwriters and mortgage originators are in the business of using their capital to earn a fair return safely. That government-backed insurance should be available only to depository banks, not firms associated with speculative traders.

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Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture.