September 22, 2011 9:01 pm

On rogues, risk-taking and restoring trust in banks

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Once a rule is set in stone, banks will find a way round. It is a cat-and-mouse game regulators are doomed to lose, writes Frank Partnoy

This week, as markets digested news about a potential debt default by Greece and a $2.3bn loss at UBS from alleged rogue trading, a new worry has emerged: several major banks are nearing insolvency and may have to be bailed out, yet again. Officials are fretting about any actions that might further harm the banks, and reports emerged on Monday that regulators are gutting the “Volcker rule,” the part of the Dodd-Frank financial overhaul that was supposed to limit US banks’ trading risks. Meanwhile, bank stocks continue to plummet; Bank of America is worth less now than at the depths of the 2008 crisis.

The central problem is that no one understands the risks hidden within banks. Not the banks’ officers and directors. Not regulators. Certainly not the banks’ shareholders. How much money would banks lose if Greece defaulted? What if the euro falls apart? Are there other rogue traders? No one knows.

The Volcker rule, which is due to be enacted next month, was meant to resolve some of these problems by prohibiting banks from taking too much risk. But a 174-page draft of proposed regulations to implement the rule includes exemptions for many risky securities. It reportedly exempts from the ban on proprietary trading “positions arising under certain repurchase and reverse repurchase agreements or securities lending transactions [and] bona fide liquidity management.” It would also allow “positions in loans, spot foreign exchange or commodities.”

Regulators apparently think they can track banks’ risks in these areas by monitoring their value-at-risk, or VAR. VAR is supposed to measure how much money a bank is likely to lose from trading, under normal circumstances. But it doesn’t account for unusual or unexpected events, such as the troubles in Greece, rogue traders – or the collapse of the housing market. VAR has been notoriously wrong. Enron’s VAR before it collapsed was just $66m. In 2007, Citigroup reported aggregate VAR of $106m, a fraction of a per cent of its ultimate losses during the crisis. UBS says the massive equity index bet by Kweku Adoboli, the 31-year-old alleged rogue trader, seemed to be low risk, with low VAR.

The financial crisis should have taught regulators that they cannot effectively monitor private sector risk-taking with tools such as VAR. It is nearly impossible for them to specify in advance what risks banks may or may not take. Once a rule is set in stone, banks will find a way around it. This is a cat-and-mouse game regulators are doomed to lose.

History also shows that rogue trading emerges predictably from activities that appear low risk. Nick Leeson and Jerome Kerviel engaged in low-VAR trading strategies that regulators would have thought safe. Future rogue traders will focus on repurchase agreements, commodities, loans, and related derivatives, instead of equity index futures.

Whatever regulators end up doing with the Volcker rule or the related recommendations of the Independent Banking Commission chaired by Sir John Vickers, an additional way to address the difficulty of regulating risk before-the-fact would be to hold senior managers responsible after-the-fact for gross negligence in monitoring risk. Regulators could require that bank leaders certify they have adequately examined and are monitoring the risks associated with their trading operations, in the same way executives now sign annual certifications of financial statements under the Sarbanes-Oxley Act. Indeed, the recent Volcker rule draft appears to leave open the question of whether bank executives will have to sign attestations to enforce the proprietary trading ban. It would be easy to add a sentence here, for the executives to state that they were not grossly negligent in monitoring the banks’ risks.

Current rules permit directors and officers to avoid personal liability for gross negligence. That is a wise rule for most business decisions: courts are generally not skilled at assessing business judgment. But risk is different. Why should a bank manager who is grossly negligent in supervising risk avoid liability?

Shareholders might never be able to understand the risks of modern banks, and current regulatory approaches will not give them much confidence. But if they knew that senior managers had agreed to be personally liable for gross negligence in monitoring risk, they might trust the banks more. Without trust, it is hard to see how banks can recover.

The writer is professor of law at the University of San Diego

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