We all know the story of Barings Bank and Nick Leeson. The lesson from that debacle is do not let your front-office run the back-office as the risk it carries is that your salesperson can book orders, pay commission and run the accounts whilst fiddling with the risk controls, compliance and accountabilities. An explosive mixture that will blow up in the face of management when, not if, the volatility is exposed.

Now, we all know that Barings Bank should never happen again don’t we? Yet in 2002, AIB announced the rogue trader dealings of John Rusnak who lost the bank almost $700 million by writing non-existent options sales and booking the fictitious premiums from them as revenue. Another individual running both front and back office and causing major operational risk.

However, that could never happen again could it? Yet, we currently have a case in Australia of exactly the same nature. In March 2005, the former head of National Australia Bank’s FX options desk, Luke Duffy, made an appearance in court to plead guilty to making $360 million in losses.

The charges were brought after an investigation by the Australian Securities and Investments Commission (ASIC) into the trading by Duffy and his team in foreign exchange and foreign exchange options. The ASIC brought the charges after discovering that the FX desk entered false information into the bank’s accounting systems so that they could create imaginary profits. Wow! That sounds like the same crime as Rusnak and Leeson. You would have thought that after a decade of knowing the operational risks of front office running the back office we could have avoided this happening again, so how did it happen?

One answer is poor management control. It is pretty obvious that sales people (traders) should not be allowed to pay their own commissions and run the back office order book (operations). There needs to be some control in place and the management controls can be addressed through effective internal structuring combined with decent operational risk strategies, but there is a more fundamental issue at stake here.

John Rusnak, Luke Duffy and company in the 2000’s are all in a position where they are dealing with increasing complexity fuelled by technology. The more complex the operation, the easier it is to falsify and the harder it is to catch. In particular, it seems obvious that front office should not run the back office but, if the operation is so complex that management find it hard to see the separation of the front and back office then, in theory, you could almost get away with anything … until the volatility of the operation exposes itself.

This is because we live in a complex world turbo-charged by hi-tech and inordinately convoluted trading strategies. So let’s go back to a simpler world of twenty years ago.

Back in 1987, Oliver Stone released the movie 'Wall Street'. In the film, Michael Douglas makes an interesting speech about greed:

"The point is, ladies and gentleman, is that greed -- for lack of a better word -- is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms -- greed for life, for money, for love, knowledge -- has marked the upward surge of mankind. And greed -- you mark my words -- will not only save Teldar Paper, but that other malfunctioning corporation called the USA."

OK, so greed is good.

But, back in 1987, there were not that many ways to be greedy without being caught. In 1987, we lived in a simpler world. A world where Microsoft was not really known and the leading technologies were called DEC VAX’s. Gigabytes were something you heard about in science fiction movies and people thought the Internet was something to do with have a passion for fishing.

Back in 1987, almost everything that was being traded was written down and could be tracked and, if it was not written down, it was probably illegal.

Technology-charged financial options and derivatives are so complex today that few in senior management can effectively manage the risks that lie therein.

As a result, greed can be served in many forms through complex trading strategies. No wonder, when Alan Greenspan was discussing the issues of corporate governance post-Enron and WorldCom with the Federal Reserve Board, he said: "It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed have grown so enormously."

Kenneth Lay and Bernard Ebbers, the disgraced chief's of Enron and WorldCom respectively, were lauded and applauded as the world’s greatest CEO’s only four years ago.

Take this quote from ChiefExecutive.net in December 2001: "Bernard Ebbers of WorldCom placed first among value-creating CEOs for the past two years.” Or take this interview with Kenneth Lay, CEO of Enron, with Business Week in August 2001, “We think the company is on solid footing, and we're looking forward to continued strong growth. We had a very, very strong first half, including second-quarter net income up 40%, earnings per share up 32%, and operational physical volume delivery up 60%. In the last five years, we have had 25% per year compounded annual growth in earnings per share.”

What could have brought these firms and individuals down to their knees so suddenly?

You guessed it, turbo-charged options and derivatives trading using highly complex trading strategies, arbitrage, credit derivatives and so on.

When WorldCom went belly-up, no-one could tell how much the firm had lost. Initially, losses were estimated at $4 billion, then $7, $9 and most recently $11 billion. The reason is that the complex trading strategies employed by the firm to buck revenues were only discovered gradually after their collapse. Meanwhile, Enron went bankrupt in December 2001, but by summer 2002 had $6 billion in cash sitting in the bank … thanks to options trading coming good.

Until you can accurately measure the risk exposures created by complex, turbo-charged trading strategies, no firm is safe from corporate collapse.

As a result, we should see as much focus upon creating technology solutions that accurately report and analyse risk exposures, operational risk and value-at-risk, as we do for solutions that allow the creation of complex options, derivatives and futures instruments.

Even with that technology capability, management within institutions will still need to be highly vigilant towards operational risk from the human perspective. After all, the Duffy’s and Rusnak’s were only exploiting the same loopholes that Leeson wormed through ten years before.

That is where Sarbanes-Oxley kicks in. In the case of Lay and Ebbers, their excuse is "aw shucks", as in "aw shucks, I’m only the chief exec and it was the chief financial officer who messed up – I don’t understand the financial stuff".

Suffice to say, that Sarbanes-Oxley rules out that defence and so there should be much more vigilance in the echelons of power to demonstrate accountability and integrity.

In the case of financial instruments, that should mean if you do not understand it, do not buy it. Now, that could get interesting as it should mean much more creativity to generate future instruments that deliver high returns whilst clearly elucidating the risks inherent in such products.

As both Sarbanes-Oxley and Basel II make clear, the human aspects of risk are just as important as the technological, and the two must work hand-in-hand if we are to protect our corporate and financial futures.

Chris Skinner is a director of TowerGroup and founder of ShapingTomorrow.com.
Web links: www.towergroup.com and www.shapingtomorrow.com
Author's email: Chris Skinner