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The Return of the Rogue THE RETURN OF THE ROGUE Kimberly D. Krawiec∗ The “rogue trader”—a famed figure of the 1990s—recently has returned to prominence due largely to two phenomena. First, recent U.S. mortgage market volatility spilled over into stock, commodity, and derivative markets worldwide, causing large financial institution losses and revealing previously hidden unauthorized positions. Second, the rogue trader has gained importance as banks around the world have focused more attention on operational risk in response to regulatory changes prompted by the Basel II Capital Accord. This Article contends that of the many regulatory options available to the Basel Committee for addressing operational risk it arguably chose the worst: an enforced self- regulatory regime unlikely to substantially alter financial institutions’ ability to successfully manage operational risk. That regime also poses the danger of high costs, a false sense of security, and perverse incentives. Particularly with respect to the low-frequency, high-impact events—including rogue trading—that may be the greatest threat to bank stability and soundness, attempts at enforced self- regulation are unlikely to significantly reduce operational risk, because those financial institutions with the highest operational risk are the least likely to credibly assess that risk and set aside adequate capital under a regime of enforced self-regulation. ∗ Professor of Law, University of North Carolina School of Law. [email protected]. I thank Susan Bisom-Rapp, Lissa Broome, Bill Brown, Steve Choi, Deborah DeMott, Anna Gelpern, Mitu Gulati, Donald Langevoort, Marc Miller, Eric Posner, Steve Schwarcz, Jonathan Wiener, David Zaring, and workshop participants at the University of Arizona James E. Rogers College of Law, Duke Law School, and Fuqua School of Business for helpful comments on earlier drafts. I also thank Andrew Furuseth for valuable research assistance. 128 ARIZONA LAW REVIEW [VOL. 51:127 INTRODUCTION The rogue trader—a figure that captured public attention in the 1990s1— has returned to the spotlight, largely due to two phenomena. First, market volatility stemming from problems in the U.S. mortgage market spilled over into stock, commodity, and derivative markets worldwide, causing large losses at many financial institutions and bringing to light previously hidden unauthorized positions. As a result, a number of financial institutions, including Société Générale, recently have disclosed large rogue trading losses. The French investment, banking, and financial services group revealed in January 2008 that a junior trader, Jerome Kerviel, had lost over $7 billion on unauthorized trades in equities and equity index futures, becoming the largest rogue trader in history.2 More broadly, the debilitating losses at many financial institutions in the wake of the current credit crisis—while not specifically attributed to rogue employees— have been blamed to a large extent on lax internal controls and oversight, combined with an industry culture that sacrificed prudent risk management in the pursuit of superior profits.3 Second, the rogue trader has returned to prominence due to domestic and international regulatory changes that have forced banks worldwide to focus more attention on operational risk, an important component of which is rogue trading. Specifically, the Basel II Capital Accord requires banks to include in their capital charges amounts sufficient to protect against anticipated operational losses, including losses from unauthorized trades, transforming what was once a residual risk category into a growing multi-billion dollar risk management industry.4 1. For example, numerous popular books and movies memorialized infamous rogue traders of the decade, such as Nick Leeson and Joseph Jett. See generally LUKE HUNT & KAREN HEINRICH, BARINGS LOST: NICK LEESON AND THE COLLAPSE OF BARINGS PLC (1996); JOSEPH JETT & SABRA CHARTRAND, BLACK AND WHITE ON WALL STREET: THE UNTOLD STORY OF THE MAN WRONGLY ACCUSED OF BRINGING DOWN KIDDER PEABODY (1999); NICK LEESON & EDWARD WHITLEY, ROGUE TRADER: HOW I BROUGHT DOWN BARINGS BANK AND SHOOK THE FINANCIAL WORLD (1996); JUDITH H. RAWNSLEY, TOTAL RISK: NICK LEESON AND THE FALL OF BARINGS BANK (1995); ROGUE TRADER (Miramax 1999). 2. Other reported losses include: MF Global ($141.5m), Caisse d’Epargne (EUR 600m), Crédit Agricole (EUR 250m), Credit Suisse (CHF 2.86bn), Lehman Brothers (undisclosed amount), Merrill Lynch ($18m), and Morgan Stanley ($120m). Scheherazade Daneshkhu, Caisse d’Epargne in €600m Loss on Derivatives, FIN. TIMES, Oct. 18, 2008, at 20; Associated Press, Rogue Wheat Trader Blamed for $141 Million Loss, N.Y. TIMES, Feb. 28, 2008, available at http://www.nytimes.com/2008/02/28/business/apee-wheat.html; Louise Story, A Question of Value, N.Y. TIMES, June 20, 2008, at C1. 3. Eric Dash & Julie Creswell, The Reckoning: Citigroup Saw No Red Flags even as It Made Bolder Bets, N.Y. TIMES, Nov. 23, 2008, available at http://www.nytimes.com/2008/11/23/business/23citi.html (blaming Citigroup’s $65 billion loss on poor risk controls, lax oversight, and a corporate culture that emphasized greater risk taking in an attempt to expand market share and profits). 4. CELENT, OPERATIONAL RISK MANAGEMENT: THREE, TWO, ONE . LIFTOFF? 4 (2006), http://www.celent.com/reports/OpRiskMgmt2006/OperationalRiskMarket.pdf (predicting a growth in operational risk management expenditures at a compound annual rate of 5.5%, from $992 million in 2006 to $1.16 billion in 2009). 2009] RETURN OF THE ROGUE 129 With this move, the Bank for International Settlements located operational risk management squarely within the category of “enforced self- regulation,” also sometimes referred to as “responsive regulation,” “negotiated governance,” or “collaborative governance.” Although the Basel II Accord requires banks to protect against potential operational losses by holding capital specifically allocated for that purpose, it also gives them an unprecedented amount of flexibility in choosing how to measure operational risk and the resulting capital requirement. For example, under the Advanced Measurement Approach (AMA)— the most liberal of the three approaches available to banks for calculating the operational risk capital charge—banks are allowed to choose their own methodology for assessing operational risk. Critics have raised a number of objections to the Basel II operational risk provisions, including a lack of definitional clarity, concerns over data scarcity, and objections that the necessary modeling techniques are insufficiently developed. Few, however, have examined the Basel II operational risk requirements as a species of enforced self-regulation with its attendant costs and benefits. Theories of enforced self-regulation have been extremely influential, both in the academic community and among regulatory agencies, courts, and legislatures. Indeed, the international banking community itself embraced enforced self-regulation in 1996, when the Basel Committee allowed regulatory minimum capital requirements covering the market risk exposures arising from banks’ trading activities to be based on banks’ own internal risk measurement models. Although this move was widely supported by both regulators and the banking industry at the time, whether such broad-based support will survive the current financial crisis, which many blame on faulty market and credit risk modeling, remains to be seen.5 Many researchers, including this author, have criticized enforced self- regulatory regimes in other contexts on a variety of grounds. This is not to suggest that enforced self-regulation can never provide meaningful benefits. In theory, enforced self-regulation provides an opportunity for innovation and creativity in establishing workable and cost-effective solutions to the problem of operational risk management. Moreover, under certain conditions, this goal appears to have been achieved in practice by some, though far from all, enforced self-regulatory regimes. Assessing the success of enforced self-regulation, however, presents measurement problems, mixed empirical results, and substantial debate among researchers. In short, even many proponents of enforced self-regulation concede 5. See, e.g., Dash & Creswell, supra note 3, at 4 (reporting from anonymous sources that Citigroup’s risk models—like those of many other financial institutions—never accounted for the possibility of a steep nationwide downturn in the housing market and concluded that the possibility of substantial defaults on its subprime portfolio was so remote that it was not included in scenario analyses); Steve Lohr, Wall Street’s Extreme Sport, N.Y. TIMES, Nov. 5, 2008, at B1; Joe Nocera, Risk Management, N.Y. TIMES MAG. (Jan. 2, 2009), available at http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?_r=1& scp=1&sq=%22joe%20nocera%22%20risk&st=cse (highlighting the debate between those who blame the current financial crisis on the reliance on statistical models, such as value-at- risk (VaR), that ignore extreme tail events and those who lay the blame on human error in using and interpreting the models). 130 ARIZONA LAW REVIEW [VOL. 51:127 that its efficacy is highly context-dependent and influenced by a number of factors, including the types of incentives and penalties provided by the regulation, the nature of the problem it is designed to address, and the particular characteristics of the regulated group.6 Leaving aside debates about enforced self-regulation’s viability in other contexts, I argue in this Article
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