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Analysing the Cases of Nick Leeson, Jérôme Kerviel, and Kweku Adoboli in Light of the Control Balance Theory

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Analysing the Cases of Nick Leeson, Jérôme Kerviel, and Kweku Adoboli in Light of the Control Balance Theory Behavioural patterns in rogue trading: Analysing the cases of Nick Leeson, Jérôme Kerviel, and Kweku Adoboli in light of the control balance theory Hagen Rafeld (Vice President, Divisional Control Office, Global Markets Division at a Frankfurt based Financial Institution) Dr. Sebastian Fritz-Morgenthal (Expert Principal, Bain & Company, Inc.) Agenda 1 Introduction p. 3 2 Charles Tittle’s Control Balance Theory (CBT) p. 5 3 The Rogue Traders Leeson, Kerviel, and Adoboli p. 7 4 Applying CBT p. 11 5 Conclusions p. 13 References & Further Reading p. 15 Rafeld & Fritz-Morgenthal Behavioural Patterns in Rogue Trading 2 1 _ Rogue Trading: Historic Overview Rafeld & Fritz-Morgenthal Behavioural Patterns in Rogue Trading 3 1 _ Rogue Trading: Historic Overview (cont.) Source: Hornuf and Haas (2014), Skyrm (2014), and Wexler (2010, p. 6); enriched with own research. Source: Hornuf and Haas (2014), Skyrm (2014), and Wexler (2010); enriched with own research. Global nature & reoccurring phenomenon rogue trading; appearance in various markets and jurisdictions Re-occurring typology/profile: Average rogue trader is male, in its mid-thirties, un- detected for more than 2 and a half years, creates a financial damage of more than $ 1.5bn, and is sentenced to jail for about 5 years Rafeld & Fritz-Morgenthal Behavioural Patterns in Rogue Trading 4 2 _ Tittle’s Control Balance Theory (CBT) Integrated criminological theory, drawing elements from learning, anomie, conflict, social control, labelling, utilitarian, and routine activities theories Equipped with interdisciplinary components, CBT is designed to explain and account for all types of deviant behaviour but also for conforming behaviour (Piquero 2010, p. 957) Initial formulation in 1995 (reply to critique in 1997 and 1999) and major revision in 2004; empirically tested in different domains (e.g. sex offenders, gender differences, policy deviance, rational choice implications, street youth crime/drug use, computer deviance) Key theory paradigms: (1) The amount of control to which an individual is subjected to relative to the amount of control an individual can exercise determines the probability of deviance occurring as well as the type of deviance that is likely to occur (Tittle 1995, p. 135) (2) Tittle interprets deviant behaviour as a device or manoeuvre helping the individual to escape from deficits and extending surpluses of control (3) Motivation triggered by provocation in intersection and favourable alliance with the variables control ratio (in an unbalanced status), opportunity, constraint, and self-control may lead to deviance Rafeld & Fritz-Morgenthal Behavioural Patterns in Rogue Trading 5 2 _ Tittle’s Control Balance Theory (CBT) (cont.) • Balanced control ratio leads to conformity/non-deviant behaviour • Unbalanced control ratio predisposes an individual to deviant behaviour – two Control ratio status (1) control surplus and (2) control deficit • Push for corrective action(s) that is most effective for rebalancing control • Desire for autonomy is almost universal for human beings; only slight variations Predisposition from individual to individual towards deviant • Trying to escape from control over oneself & exercising more control than one motivation is experiencing • Presence of certain stimuli or provoking parameters, e.g. external events, Provocation structural realities, and/or control impingement Motivation • Triggered by provocation; draws attention to control imbalances • Suitable targets, situational circumstances, physical realities Opportunity • Important: Opportunity frequency and magnitude • Opportunity seeker vs. opportunity taker (Weisburd et al. 2001) • Seriousness: Potential magnitude of restraining responses or controlling reactions Constraint from others, i.e. counter control or (social) sanctions • Situational risk: Variable of detection risk and condemnation risk • CBT assumes, acting individuals are self-regulated and non-impulsive Self-control • Provocations create desire for (immediate) action, prevented or not by self-control; linkage to crisis responder (Weisburd et al. 2001) Rafeld & Fritz-Morgenthal Behavioural Patterns in Rogue Trading 6 3 _ The Rogue Traders Leeson, Kerviel, and Adoboli Nick Leeson Jérôme Kerviel Kweku Adoboli at Barings Bank at Société Générale at UBS Education High school diploma, followed by Decent degree at secondary university; straight to joining Coutts & Co, Morgan Stanley, Société Générale respectively UBS after university and finally Barings Securities Background Former trade support/control; knowledge of back office process and controls key to fraud Motive No personal gain except bonus Age (when detected) 28 31 31 Year (when detected) 1995 2008 2011 Time to detect 2y 6m 2y 6m 2y 11m Total Loss $ 1.3bn / GBP 827m $ 6.9bn / € 4.9bn $ 2.3bn Market Activity S&P 500, DAX, and Euro-Stoxx Nikkei Index Futures European Stock Index Futures Futures Imprisonment 6y 6m 5y of which 2y were suspended 7y of which 3y 6m were suspended Fine against Trader Full restitution of € 4.9bn - - (rejected in 2014) Fine against Institution - € 4m $ 48m Rafeld & Fritz-Morgenthal Behavioural Patterns in Rogue Trading 7 3 _ Nicholas (“Nick”) Leeson at Barings Bank Risk Management Failures Modus Operandi Early Warning Signals and Control Weaknesses • Switching trading strategy • Lack of supervision and no • Disregarding external (Leeson took buy and sell segregation of duties warning signals from other orders for Nikkei index banks and SIMEX futures from Barings’ clients • Investment performance to exploit price gaps and risk measures (mis- • Inadequate follow up on between SIMEX and OSE) leading VaR; deceptive Internal Audit findings on Sharpe Ratio) segregation of duties • Usage of an ‘error’ account (88888): Almost 5,000 • Barings’ financial reporting • Leeson’s financial mis- hidden contracts per end of systems (‘First Futures’ in demeanours, i.e. trader Jan. 1995 – increase to London and ‘CONTACT’ in license rejection in London 61,000 end of Feb. 1995 Singapore) due to unpaid debts • Trade price manipulation • Insufficient understanding/ • Trading strategy vs. (excessive option selling) challenge by back office disclosed profitability • Unauthorized use of client’s • Controls failed to keep pace • ‘Star trader’ status margin accounts with business growth of Barings in Singapore Rafeld & Fritz-Morgenthal Behavioural Patterns in Rogue Trading 8 3 _ Jérôme Kerviel at Société Générale Risk Management Failures Modus Operandi Early Warning Signals and Control Weaknesses • Recording fictitious trades, • Ineffective control systems • JK’s level of earnings: 60% with significant offset (fragmentation of controls, of the entire desk (value date considerably heavy reliance on manual (consisting of 8 traders); later than transaction date) processing, lack of controls brokerage commission: and cancellation before to identify rogue trading) 30% of JK’s official earnings value date (947 trans- actions) • Control weaknesses, identi- • EUREX questioning (twice fied by Internal Audit but via official inquiry) • Recording pairs of fictitious not remediated transactions (115 trans- • Cash flow monitoring of actions) • Staff risk, i.e. inexperience € 1.3bn end of Jan. 2007 of Kerviel’s manager and • Recording of 9 intra-month lack of experience and • Accounting irregularities provision flows (‘flux pro’), seniority in back/middle and discrepancies i.e. modelling bias to adjust office teams unauthorized positions; • Limit (€ 125m) has been biggest one of € 1.49bn • Available control personnel breached by JK by € 10m early Jan. 2008 via JK’s vs. transaction volume trading assistant growth in equities division • No vacation taking Rafeld & Fritz-Morgenthal Behavioural Patterns in Rogue Trading 9 3 _ Kweku Adoboli at UBS Risk Management Failures Modus Operandi Early Warning Signals and Control Weaknesses • Booking of fictitious futures • Mismanaged transfer of the • Trading mandate breaches and Exchange Traded Exchange Traded Funds (1) & limit breaches (4) Funds trades with deferred desk; London desk settlement dates (& cancel- supervisor was based in NY • Increase in proprietary lation before settlement) trading revenues ($ 11.7m • Inadequate trader man- for FY 2010 to $ 15.9m in • Late booking of genuine dates and not formally Q1 and $ 47.8m in Q2 11) external futures trades into documented risk limits front office risk systems to • Cancel, amended, and late misreport risk exposure and • Insufficient understanding/ booked trades (‘C/A/L’), P&L challenge by middle office generating P&L of $ 0.5bn, signed off w/o investigation • Profit smoothing via so- • Ineffective operational risk called umbrella account framework, i.e. review of • Unauthorized P&L adjust- (reserve/wash account) – SocGen’s rogue trader – no ments (one of € 1bn) and which was against UBS’ remediation of identified reconciliation breaks (e.g. policy to report P&L when findings/weaknesses CHF 209m in Aug. 2011 due earned to misbooked trades) • Ineffective control systems Rafeld & Fritz-Morgenthal Behavioural Patterns in Rogue Trading 10 4 _ Applying CBT Source: Own representation based on Tittle (2004, p. 419). Rafeld & Fritz-Morgenthal Behavioural Patterns in Rogue Trading 11 4 _ Applying CBT (cont.) Primarily control surplus (rather deficits) relate to exploitative acts in the corporate context, i.e. white collar and corporate crime (Rogue) traders in control surplus stage are highly motivated to extent their control surplus – generating shifts of control Acting is mostly combined with reckless
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