UBS Finds Risk Management Stress Test Costly

What's the harm in having a risk management system in place, but ignoring the alarm bells when they seem inconvenient? No harm at all, if you don't mind seeing your quarterly net profit decline by 39%, and revenue slide by 4%.

Swiss banking giant UBS announced those results Tuesday, saying they reflected not only "market conditions," but also the recent "unauthorized trading incident" that resulted in its losing 1.8 billion Swiss francs ($2 billion). One piece of good news is that the actual losses were $300 million less than the bank had originally estimated.

UBS had discovered the unauthorized Delta One trades last month in its Global Synthetic Equity business and alerted London police. That same day, they arrested and later charged a 31-year-old trader, Kweku Adoboli, on suspicion of fraud and abuse of his position.

Delta One trades are a form of complex derivatives trading, and by all accounts, incredibly opaque. Interestingly, rogue trader Jerome Kerviel at Societe General in 2008 hid Delta One trades, ultimately resulting in losses of $7 billion. Accordingly, while Delta One trades might offer significant revenue potential, their potential for insider abuse--not least when traders get in over their heads and double down, seeking a quick fix for losses--should cause banks to carefully monitor such trades.

"Risk and operational systems did detect unauthorized or unexplained activity but this was not sufficiently investigated nor was appropriate action taken to ensure existing controls were enforced," UBS interim chief executive Sergio Ermotti told employees in a memo earlier this month. "We have accepted the resignations of the co-heads of Global Equities. Firm disciplinary action will be taken against further individuals in Equities and across other responsible functions. We have also taken specific steps to address the failures identified."

How did one of the world's biggest banks fail to heed the alarm bells, despite its former chief executive, Oswald Grubel--ousted over the unauthorized trading--having recently boasted that UBS had "one of the best" risk management programs in the business? "Having controls in place is one thing. Acting upon them is a different one," Martin Kuppinger, principal analyst at market researcher KuppingerCole, tells me. "That's why I strongly believe in automated controls which just can't be ignored that easily. But even that's about knowing risks, having controls in places, and the right processes and people."

Kuppinger, however, also cautions that until the full details of the UBS incident emerge--the bank has said it will release more details after the current investigation wraps--no one should jump to conclusions. "Without having proven details on what really happened and the reasons behind it, I won't blame UBS," he said.

Still, might UBS have been slow to rein in its massively profitable investment banking group's practices, especially given the firm's history of poor risk management oversight? "This story absolutely does suggest a deeper culture challenge," says Alexei Miller, executive VP at DataArt, a custom application development shop that builds risk management systems for financial services firms.

But, he says, no system, check, or balance--including governance, risk, and compliance (GRC) controls--is 100% foolproof. "The whole incident is not, in the end, about systems or controls or risk officer's power," says Miller. "No system will ever guarantee absolute protection. It is human behavior, first and foremost. A clever and well-connected bad apple will always find a way around risk controls. How many instances of unauthorized trading will we never learn about, because they go the trader's way?"

In the case of Societe Generale, Kerviel avoided detection for some time by using other people's passwords to subvert the access management system. He also bypassed the risk management system, based on his understanding of how it worked.

"Banks are still learning--not only from SocGen. But it's a process which takes its time. SocGen has alerted banks, and UBS added to this," says Kuppinger. Overall, banks are getting better at addressing risk management. "And honestly, they overall are much better than other industries," he says.