Barings redux?

March 21, 2008 3:28 AM

Credit Suisse will take a $2.65 billion hit to earnings and post it's first quarterly loss since 2003 due, to no small part, to deliberate mispricing of asset backed securities by several traders operating at all levels of seniority across the 143 year old institution.

Yesterday Credit Suisse was the goss on trading desks during the day and late into the night at pubs. And, of course, parallels were raised between this event and the collapse of Barings Bank in 1995, singlehandedly brought about by one Nick Leeson.

So is this another Barings, will Credit Suisse also collapse? Of course in time Credit Suisse will more than likely cease to exist, but odds are this single event won't shut it down, even though much larger than the Barings fraud, and (apparently) much more pervasive.

Why you ask? What's different this time? Very reasonable question. Well, the folks responsible for regulating the global financial system (to the extent it can be regulated that is) are well aware of risk. For example, the risks of new instruments operating at unprecedented scales of deployment, leverage and complexity. Or the risk of highly interconnected financial institutions, each dependent to some degree upon the stability of the other. But the regulators are also concerned, to no small extent, with what perhaps can be considered, the oldest risk - moral hazard.

To deal with this (and other, related risks) the Basel II Capital Accord, effective January 1st 2008, finally integrated Operational Risk into the larger regulatory umbrella.

Earlier versions of the Basel Accord dealt with Market Risk, or the possible change in value of assets held by a bank due to market forces, and Credit Risk, or the possible loss a bank might face due to a counterpart defaulting.

The Basel Accord requires banks to act prudently, and set aside money - Economic Capital - sufficient to cover both expected and unexpected losses caused by the aforementioned risks.

And this time it is indeed, different. Unlike 1995, now banks are required so set aside money to cover, cushion the blow, if you will, of losses directly related to the operation of the institution; operational risk, by definition.

The part of the Basel II Accord dealing with Operational Risk identifies seven different event types; effectively how losses can be realised due to the operation of a financial institution. Banks are required to forecast both the frequency and impact of all such events, and set aside adequate capital such that the stability of the institution - as well as the wider global financial system - won't be threatened, should the worst happen.

As it would seem this event slots rather nicely into the Basel II definition of internal fraud, or "Loss due to acts of a type intended to defraud,...", one can assume that adequate capital is indeed available to compensate for this loss.

So another Barings? In a single word: no. Both had fraud and personal gain as the primary drivers of the bank's loss. And perhaps worse, the Credit Suisse incident seemed to be the work of an organised group of several traders.

But it was different this time due to two factors, both attributable to Basel II: first, banks and other financial institutions are required to first forecast, then monitor and report such losses (while there still may be dirty laundry in the boys room it's harder to hide as the stink gives it away). And secondly, they are required to set aside capital, in advance, to cover forecasted losses.


Yes, I admit it. This is Newsfilter, but its Newsfilter 2.0! And Newsfilter 2.0 both educates and pre-empts, lest others seize this event as further "evidence" that the global financial system is out of control

posted by Mutant (33 comments total)

Also, the Barings thing seemed also to be the result of gross incompetence, both on the part of the bank and the young Mr. Leeson. This seems somehow more sinister.
posted by psmealey at 4:07 AM on March 21, 2008

Was this meant to be a comment rather than an FPP?
posted by cillit bang at 4:44 AM on March 21, 2008

This financial crisis is unfolding like an airline delay - slowly the bad news is leaked out in small spoonfuls to avoid the riot which would ensure íf they told the whole truth at once.

More to come for certain.
posted by three blind mice at 5:00 AM on March 21, 2008

One of the things that I had forgotten about in the 15 or so years since I've been out of the business, is that most banks do not have the financial resources to settle all accounts at the end of the day. The complex and numerous obligations and financial instruments that keep these banks interconnected and interdependent in almost all cases exceed their current liquidity (particularly in this market). So, if there's ever a "run" on a bank (such as the case last Friday on Bear Stearns), it will go under. When the "trust" disappears, pretty much any bank can go under in less than a day. This is pretty much what happened with Drexel Burnham in 1990 as well. It's all balanced on a razor's edge, even in the best of times.

If this truly was a case of a bunch of assholes manipulating markets to protect their end of year bonuses, they should be strung up. Leeson was simply a fool, in over his head and not brave enough to ask for help, these guys are, well if not evil, then something pretty close to it.
posted by psmealey at 5:08 AM on March 21, 2008

psmealey -- "...he Barings thing seemed also to be the result of gross incompetence, both on the part of the bank and the young Mr. Leeson. This seems somehow more sinister."

I was working for Deutsche in New York at the time of the Barings blowup (Strategic Risk Management actually), and the firm held several post collapse seminars, reviewing the event in great detail.

The Risk Management function didn't exist in APAC, allowing Leeson to not only assume positions on behalf of the firm (front office), but and clear his own trades (back office).

Also, he operated unilaterally, and apparently had no direct supervisor in the region.

But I agree this event is more sinister, especially so as we're seeing this fraud (apparently) cutting across several layers of management.

My own view? Well, since 2006 we knew a US recession was on the horizon (the yield curve never lies). And we also know that most investment banks are notorious for their "good times / bad times, hiring and firing". In other words, traders and their support staff tend to be shown the door first in bad times.

So maybe these guys knew their jobs were at risk, and wanted to go out with a golden handshake? Seems plausible, especially so as we're seeing the leading edge of job cuts in both The City (London) and Wall Street (New York).

"If this truly was a case of a bunch of assholes manipulating markets to protect their end of year bonuses, they should be strung up."

Well, I'd settle for yanking their licenses and bans from working in the securities business. The young guys temporary, but anyone up the chain of command, who gave the troops marching orders, who were responsible for not only organising this fraud but coercing others to participate, a lifetime ban. Unacceptable.


cillit bang -- "Was this meant to be a comment rather than an FPP?"

Read the fine print - it was meant to both educate and pre-empt. Basel is a specialists area, none of the news articles I've read (outside of financial press more than likely not available to most MeFi readers) make absolutely ANY MENTION of capital adequacy and regulatory frameworks that we've put into place post-Barings. Several do, however, reference Barings.

And I have no doubt, based on debate in other FPPs, that most folks here don't have a strong grasp on how banks and modern financial institutions are regulated. I'm not trying to be disrespectful to anyone mind you, there are broad gaps in my knowledge that MeFi has helped to close and this post (the first of many I can assure you!) is my attempt to do the same for banking & finance. As I mentioned to one of the mods recently, I'd be a piss poor part time academic if I were to complain about ignorance but not try to help (that was in reference to a post I've been working on recapping the history of derivatives).

So, I guess if someone had beaten me to the post (with the inevitable shrill and emotive pronoucements of doom & gloom) I'd have weighed in with a comment, perhaps somewhat briefer as the actual event would have already been linked.
posted by Mutant at 5:31 AM on March 21, 2008 [2 favorites]

these guys are, well if not evil, then something pretty close to it.

How about just plain old greedy? We'll call them greedy-doers.
posted by three blind mice at 5:33 AM on March 21, 2008 [2 favorites]

lest others seize this event as further "evidence" that the global financial system is out of control

Yes, investment banks blow up and get bailed out all the time when the market is healthy. Uh huh. Sure.
posted by Malor at 5:36 AM on March 21, 2008

Malor -- "Yes, investment banks blow up and get bailed out ..."

We all (myself & the rest of the financial industry) have missed the bail out part of this saga. Can you please cite source and provide further details of who bailed out Credit Suisse?
posted by Mutant at 5:49 AM on March 21, 2008 [1 favorite]

How about just plain old greedy? We'll call them greedy-doers.

What kind of settlement did greed get when it got the divorce from evil?
posted by srboisvert at 6:37 AM on March 21, 2008 [1 favorite]

Also, CIT, one of the largest independent commercial finance companies, had a bit of a liquidity crisis yesterday. It drew down $7.3 billion of bank lines, the maximum it had available, and announced that it would seek to sell of $5 - $7 billion in assets (roughly 10% of its on balance sheet investments).

A lot of people in these threads wonder how the failure of big finance companies will affect them. Well, if CIT goes into bankruptcy, the fall out could be quite obvious. CIT is the largest "factor" in the US, which means it provides short-term financing secured primarily by accounts receivable to small- to medium-size companies that have limited access to other financing sources. The apparel, low-priced furniture and jewelry industries would be hardest hit--CIT finances the companies that manufacture or distribute products found in Target, Wal-Mart, Kohl's, TJ Maxx, Ross, and others.
posted by mullacc at 7:12 AM on March 21, 2008 [1 favorite]

This financial crisis is unfolding like an airline delay - slowly the bad news is leaked out in small spoonfuls to avoid the riot which would ensure íf they told the whole truth at once.

This is no more the fault of the recent economic downturn than was Enron's collapse the fault of the tech crash. What you have here is a pretty straightforward case of good, old-fashioned fraud. The sort of thing that happens even in the best economic conditions.
posted by Afroblanco at 7:22 AM on March 21, 2008

lest others seize this event as further "evidence" that the global financial system is out of control

all a foolproof system needs to break it is a bigger fool - and if history has shown us anything it's the inevitability of systems reacting in ways that the controllers had not anticipated

that is not the same as proclaiming that the sky is falling due to this or any other aspect of the current crisis - it's a warning against complacency, that's all - there is some conceivable combination of factors that could spell disaster for this or any other system - i tend to believe that we haven't quite seen that combination yet, but i'm not smart enough to know
posted by pyramid termite at 7:26 AM on March 21, 2008

The Basel Accord requires banks to act prudently, and set aside money - Economic Capital - sufficient to cover both expected and unexpected losses caused by the aforementioned risks.

Unfortunately, that isn't going to do any good. Banks already set aside money which they think is sufficient to cover unexpected losses. The problem is that the industry systematically underestimates risk. Go ask any banker, and they will tell you that a credit crunch like we have today should not even happen once in 10,000 years. Banks are very good at estimating the probability of common events (small market motion), but terrible at estimating the probability of uncommon events (huge market moves).

The problem isn't regulation, it is a fundamental misunderstanding of risk on the part of nearly the entire finance community.

For more details, see Nassim Taleb's Long Now talk (mp3 link).
posted by b1tr0t at 7:28 AM on March 21, 2008 [1 favorite]

This is interesting. Until last November, when heads, mine included, rolled at Citigroup, I worked in risk analysis for Citi's response to the Basel II accords, tracking data quality metrics assessing global preparation for the 2009 adoption of the new capital adequacy rules. It's a big deal that doesn't get much ink.

Credit Suisse and the rest of the big European banks pledged to honor the accords by 2008; US banks gave themselves later deadlines. Citi pledged to finish their regulation by 2009.

Part of my job involved haranguing heads of business overseas to get with the program and send us raw information on all their accounts, which we would then plug into our models to verify that they worked. Trouble was, most of the regions weren't keeping accessible records so a lot of the work was seeing to a backlog of account data. It was a bit of a nightmare, actually.

Another part of my job involved developing and testing mathematical models by which portfolios could be aggregated into pools, or clustered, in order to mitigate risk. By grouping high-risk and low-risk portfolios together and then using the cluster, not the portfolio, as the basic unit from which risk is calculated, risk can be contained (on the books, if not in reality).

Of course, if the portfolios being grouped together are actually disparate, then significant risk in a certain type of vehicle would optimally be diffused among several clusters, with justifications for the placement based on abstruse clustering dimensions chosen mainly for the purpose of this cluster fudging.

The Basel II accords, while necessary, are a game of catch-up. New financial vehicles and markets require regulation, but the regulation takes years to deploy, while financial progress marches on. Most of Citi's response has been along the lines of, "How do we snow the regulators while disrupting our current state of operations as little as possible?". The whole point of risk management is managing risk, not hiding it.

The recent lumps Citi took were due in a large part to the kind of risk-hiding behavior I was employed to do. Of course, my project was still in the testing stages when I got my pink slip. And, of course, what Citi does is tangentially related to this recent news from Credit Suisse.

But Basel II was my tango partner for a time last year, and I get wistful and nostalgic when I hear her name.

Fact is, I was glad to lose my job, because it felt like I was organizing and facilitating lies on a massive scale, lies that might contribute to major economic collapse. Now I'm on the outside watching things fall, and kind of enjoying it, even though it sucks for everyone.

Everything is so leveraged now that if risk weights are miscalculated or smoothed over, just a little turn could catapult everything to hell. Looks like that happened at Credit Suisse. Could happen anywhere.
posted by breezeway at 7:37 AM on March 21, 2008 [11 favorites]

Well there goes my productivity for the day. Thanks Mutant.
posted by Skorgu at 7:48 AM on March 21, 2008

Nice post.
posted by taliaferro at 8:40 AM on March 21, 2008

Fantastic post Mutant. I know very vaguely about Basel, but no real details, so I find this very interesting, thanks. Keep these posts coming!
posted by triggerfinger at 9:42 AM on March 21, 2008

b1tr0t -- "Unfortunately, that isn't going to do any good. Banks already set aside money which they think is sufficient to cover unexpected losses."

Of course this will help. It clearly already has; Credit Suisse most assuredly hasn't been bailed out (my earlier question, "By who?", lest folks think a bailout has taken place, still stands) and Credit Suisse seems to be in business today (I had to go into the bank for a while and passing by their offices saw folks drifting in and out ...). Credit Suisse set aside capital, as per regulatory requirements, capital intended to shield against unexpected losses, this one included, And apparently the capital was adequate, as Credit Suisse will be posting a loss, but is (at the time of this post at least) still operating as an ongoing concern.

Big difference from Barings, where a similar event brought down the institution. The Basel II Accord covering Operational Risk hadn't been agreed yet. So there you go.


"Go ask any banker, and they will tell you that a credit crunch like we have today should not even happen once in 10,000 years."

Uhmm, sure, I'll ask myself and I'll largely agree with you about the statistical rarity of last summer, but I'm not sure where you're getting the once in 10,000 years quote from. I've read smaller numbers and I've read larger numbers. But since it's your quote, please cite source and by the way, please be aware that not all bankers will agree with your (presumably) single source. This is a very complex area, and any conclusions are subject to lots of assumptions. So you'll never get "all bankers" to agree on this. I'm not nitpicking, but this is my field both professionally and academically, and I'm genuinely curious (a point I've made in other threads when I've asked similar questions, queries that all too often go unreplied to ... )


"..it is a fundamental misunderstanding of risk on the part of nearly the entire finance community."

I'm already familiar with Taleb's work to some extent, and not just his (now it seems wildly popular) books or web accessible articles, but I've also read his primary research and journal publications. Some of this work is very, very thought provoking and he's widely cited in the literature. So that alone shows a large degree of awareness to his work by folks in banking, academia, and the regulatory communitys.

Of course Taleb's work really is concerned with what we call low frequency / high impact events; things that should happen, very, very rarely, but boy howdy when they do! I'm reading 'The Risks of Severe Infrequent Events' Taleb, N., N., Martin, G. A., Banker; Sep2007, Vol. 157 Issue 979, p188-189, and he takes both the ratings agencies and hedge funds to task.

His ideas are controversal, to say the least. And not generally accepted as "fundamental" by either the academic or financial communities for that matter.

That being said, it's good to have folks like Taleb shaking up the status quo, challenging our assumptions and perspective.



breezeway -- "US banks gave themselves later deadlines. Citi pledged to finish their regulation by 2009."

Yeah, that was one of the more ridiculous things I've ever seen in modern finance. You've got the entire global community moving to markedly strengthen individual institutions and, by induction, the global financial system. And the United States declines to (fully) participate.

Much of the pissing and moaning and justification for US banks not adopting the accord last January centered around a single error two mortgage bankers had found in one of the formulas ( 'Sharp-Eyed Bankers Spot Error in Basel II Formula.', Paletta, D., American Banker, 1/7/2005, Vol. 170 Issue 5, p1'). Unbelivable they (American banks) could get away with it.

"Part of my job involved haranguing heads of business overseas to get with the program and send us raw information on all their accounts, which we would then plug into our models to verify that they worked. Trouble was, most of the regions weren't keeping accessible records so a lot of the work was seeing to a backlog of account data."

Ah, so you were working at The Group level? Always a thankless task, to be sure, as nobody directly reports to you, and yet you can't do your job without their help.

And data is the biggest problem we've got in banking. Very, very few systems have clean, business defined interfaces. Most of the time the IT guys build something but then we have to massage and transform so much to get things into a useful form, that future auditability is - well, I won't even say its a remote possibility, 'cause sometimes it's clearly not.

"The Basel II accords, while necessary, are a game of catch-up. New financial vehicles and markets require regulation, but the regulation takes years to deploy, while financial progress marches on. "

Yeah, but at least there is something in place. The point of the entire FPP was to illustrate that, contrary to what far too many folks opine, banks are highly regulated vehicles and they simply can't hide the truth. For long, that is. There are far too many people looking at their operations from far too many angles and different view points.

If the truth is covered up it will come out, and a regulatory framework like Basel provides a mechanism for this discovery.


"Everything is so leveraged now that if risk weights are miscalculated or smoothed over, just a little turn could catapult everything to hell. Looks like that happened at Credit Suisse."

I've got to disagree here. What happened at Credit Suisse had nothing to do with risk weighted assets, regulatory capital nor the predictive power of mathematical models.

It was outright fraud and attempted theft, pure and simple.

By the way - lots of side money being bet here in London that we'll see charges before the end of next week. I don't bet myself (at least not outside the various markets I trade in), but I'm hearing odds favour someone interviewed as early as next week ... fascinating, in a train wreck kinda shameful way ...
posted by Mutant at 10:09 AM on March 21, 2008

This is no more the fault of the recent economic downturn than was Enron's collapse the fault of the tech crash. What you have here is a pretty straightforward case of good, old-fashioned fraud. The sort of thing that happens even in the best economic conditions.

People get killed every day. But when you have thousands of them dying all at once, they call it a war.
posted by tommasz at 10:15 AM on March 21, 2008

(that was in reference to a post I've been working on recapping the history of derivatives).

I'm looking forward to that post, Mutant. I've been interested in seeing the $500 trillion in derivatives covered in a way that doesn't make me think we are really standing on a precipice.
posted by ryoshu at 10:36 AM on March 21, 2008

I'm sorry, are we going to have a "ZOMG FINANCIAL COLLAPSE OF THE ENTIRE INSTITUTION OF FIAT MONEY" post every single goddamn time a financial services company deleverages a portfolio or is discovered to have mispriced an asset? Because that is going to go on for ever, just as it always has, especially at the 2.65B level.

Credit Suisse has like 1.2T in assets under management. 1.2T. Please stop posting terrible posts.
posted by felix at 10:53 AM on March 21, 2008

Mutant, you're absolutely right about that last point. I was having a momentary Chicken Little futurist spree and conflating my greatest fears with the issue at hand. This Credit Suisse thing is about theft, plain and simple.

But the hyperleveraged set-up du jour still frightens me; failures of confidence in response to scandal and loss can be crippling. I can't help but see a house of cards.
posted by breezeway at 11:02 AM on March 21, 2008

Credit Suisse has like 1.2T in assets under management. 1.2T. Please stop posting terrible posts.

There's a lot of hand-waving on MeFi, but you just committed the opposite crime. Credit Suisse does have CHF 1.4T in assets, but only 44B in shareholder's equity and 32.7B in Tier 1 Capital. The 2.9B in write-downs look tiny in comparison to the entire balance sheet, but not so tiny when compared to the bank's capital ratios. Though, CS is still relatively well-capitalized compared to some other banks.
posted by mullacc at 12:32 PM on March 21, 2008 [1 favorite]

breezeway -- "I was having a momentary Chicken Little futurist spree and conflating my greatest fears with the issue at hand."

Now that is something that happens to all of us, in the field or not, and you're probably more sensitive to it, having worked directly on Basel II in a major Money Centre bank and all. Perfectly understandable. I worry about it from time to time as well, but then I think back to The Cold War - why didn't the US and the USSR destroy each other?

Well, to some extent because of MAD each had a vested interest in not going to war.

I think the point that is lost on some folks is that nobody - retail money, bankers, regulators - absolutely nobody would benefit if the whole shithouse went up in flames (Illuminati or CIA conspiracies about global rule aside).

Its that mutual self interest which will always, especially in difficult market conditions like we're seeing now, drive banks and boards and other participants to do the right thing, even if what they're doing isn't total in their own best interests. Just my own opinion, mind you.

"...failures of confidence in response to scandal and loss can be crippling. "

Totally true. It's the same mob psychology that will drive folks to speculate wildly, to participate in bubbles that aren't warranted by the underlying asset's fundamentals (aka Traditional Bubbles, compare with Rational Expectations Bubbles which I described here).

Behavioural finance is incredibly interesting, and there's lots of money to be made by anyone who can properly integrate traditional econometric tools with data mining techniques, to capture then gauge mob psychology.
posted by Mutant at 1:20 PM on March 21, 2008

I really like Mutant's posts, but if I have to read "please cite source" one more time, I'm going to start him a Wikipedia page.
posted by bonaldi at 2:41 PM on March 21, 2008

I'm sorry, are we going to have a "ZOMG FINANCIAL COLLAPSE OF THE ENTIRE INSTITUTION OF FIAT MONEY" post every single goddamn time a financial services company deleverages a portfolio or is discovered to have mispriced an asset?

I fucking hope so, I love it when the finance geeks post.
posted by fullerine at 3:36 PM on March 21, 2008

I'm not sure where you're getting the once in 10,000 years quote from

I pulled that specific number out of thin air, but they are typically brought out whenever big crashes like this happen.

I don't work in finance, so I don't have the deep background that you have. People that I have spoken to in finance (even the quants) seem much more interested in arbing some specific products than analyzing whether their activities are creating correlations that will dramatically increase their risk.

It is nice to see that Taleb's (and Mandelbrot's) work is getting some exposure. It will be even better when it starts to make a positive impact.

things that should happen, very, very rarely, but boy howdy when they do!

I know you are being jokey here, but the idea that these "rare" events "should" almost never happen is completely bizarre. Since 1987, how many crashes have we had in world markets? Off the top of my head: the recent credit crunch, the dot-com implosion, the asian meltdown, the russian collapse. That is more than a crash ever five years, and I'm probably missing several.

Crashes are normal and common. Why is a guy who asserts this controversial? I sure would like to see crashes going away, but wishing them away hasn't made them disappear.
posted by b1tr0t at 6:46 PM on March 21, 2008

I sure would like to see crashes going away, but wishing them away hasn't made them disappear.

Me too... but it will never happen until the powers that be (in government and in business, at the same time) realize that boom cycles are every bit as damaging to the economy at large as busts are.
posted by psmealey at 7:56 PM on March 21, 2008

psmealey - I'm not sure I follow. However, even if business, government, and the population at large wanted to change, I'm trying to argue that we don't even have the mathematical tools to do the job. Or if we do, they aren't understood widely enough to be effectively used.

Of course, if the choice is between an infinitely flat and stagnant economy and one that has booms and busts, I'd definitely rather live in the one with booms and busts.
posted by b1tr0t at 8:13 PM on March 21, 2008

Of course, if the choice is between an infinitely flat and stagnant economy and one that has booms and busts, I'd definitely rather live in the one with booms and busts.

Even as an academic discussion, what you offer seems like a false choice from about 50 yards away.

Just saying that in so-called "boom times", only a few people (fewer and fewer with each successive boom) profit. At least by way of recent example, in these past 7 years of economic growth, a relatively tiny few people have grown wealthy beyond the dreams of their forebears, when overall wage growth has been stagnant, or even negative in some sectors for everyone else. So, if we are on the precipice of the next great depression, a tiny group saw enough of an upside (if any) to be able to shield themselves from bad times.

I'm not sure that the answer is a "managed economy", but (theoretically, at less) there has to be some way to at least invest some of the excesses on the upside, so that we can handle the times when we're on the back side of the yield curve.
posted by psmealey at 8:23 PM on March 21, 2008

There are whole swaths of the current economy that need to die. Plenty of paleolithic companies out there that can't adapt and are slowly falling apart.

There has been huge growth for midrange employees (and even low level people) in the tech sector, in the last seven years. Certainly the top people are making silly amounts of money, but most everyone else in their organization is doing decently well too.

Those that are embracing new technology are able to transform their businesses and stay relevant. Those that won't are falling behind.

As for the paleolithic companies, I'm not sure what to say. It sure must suck to work in the US auto industry, though the upcoming oil crunch may provide some interesting opportunities for those agile enough to take advantage of them. Tesla might be able to do it. GM probably won't.
posted by b1tr0t at 8:35 PM on March 21, 2008

Good post Mutant. Lot of learnings for peons like me.

Mutant: "...I've been working on recapping the history of derivatives"
Looking forward to that post.
posted by forwebsites at 10:08 AM on March 23, 2008

Not that it means a lot, but I just wanted to say I enjoyed b1tr0t's post. That's usually the case with many industries in a down economy--man of those dot commers that adapted through the bust are pretty solid now.
posted by Todd Lokken at 8:55 AM on April 8, 2008