Risk Management, Bank Politics and the Financial Crisis

NC: To this day, my wife is convinced that I wrote this article anonymously with only a few facts and figures changed (like the fact that I would set my alarm for 5:30). I can peronally assure the readers that this description of life at a large multi-national bank is completely accurate and eerily describes the last 12 months at my previous employer.

When you deal with the guys at the top of the pyramids at these organizations, you realize just exactly how banks could have mismanaged themselves and ultimately the economy onto the brink of abyss. And if you think the regulators were any better...

The emphasis is mine.

The author is a former head of risk at a top investment bank. He wrote on condition of anonymity.


MY ALARM went off at 5.30am and I stumbled to the kitchen to make a coffee, knowing that it could be the last day I went to work for an investment bank. It was September 15 last year and Lehman Brothers had just gone under. As a result, I had lost my bank about $1 billion (£700m).

On the train I wondered what lay before me. Losses do not come much bigger. Would they let me through the door? After 13 years in banking, it looked like my number was up. The worst thing was that none of it had come as a surprise. I had inherited the risky trades a year earlier and warned my bosses about the size of the potential losses all along, but they wouldn’t let me get out of the positions. In an investment bank, nobody wants to hear about risks in their business - not while they are making money.

Until the end of 2008, I worked in a large investment bank, managing risks for the derivatives business. I was the guy who was supposed to mop up everyone else’s problems. I had to look at all the complex trades, work out what the losses could be, then find a way to protect the bank. That’s the theory.

I saw every trade. Knowing what I knew, I could work out every trick employed by these “Masters of the Universe” to line their own pockets, whether the bank made money or not. Those who make their way to the top of the pile in banking are not the best traders, but the best politicians. When it comes to complex trades, the bosses have the wool pulled over their eyes all the time by the people they employ.

Derivatives are what really confuse everyone. It’s a term that covers a whole range of contracts but basically they are bets on the future value of something - whether that’s a share, a shipment of iron ore or even the creditworthiness of another bank.

I once tried to block a large derivative deal because the maths didn’t make sense. It just wasn’t going to make enough profit to justify the 30 years of credit risk it was going to leave on the balance sheet. But the head salesman, who was behind the trade, would be paid his bonus in one year, not 30. Needless to say, he disagreed with my analysis.

My boss and I tried to face him down. He went straight for the jugular and threatened to take the matter to the head of Fixed Income, accusing us of curtailing good client business and short-changing the shareholders. I tried to make my case but my boss’s appreciation of derivatives was weak, to say the least. I could see he had lost my point in the first sentence of my argument.

By sentence two, the head salesman had sensed the weakness and went in for the kill. He calmly said that he would ensure that we would be fired if he missed the deal and it turned out our analysis was wrong. In his opinion, our analysis was deeply flawed.

At this point, my boss’s eyes started to well up with tears. The debate ended. We had lost and my boss had chickened out, consenting to the deal with no further dissent. I left the room in disgust.

High finance had been decided by what amounted to playground politics. The client in question went bust shortly after, brought down by complex derivatives sold to it by the investment banks. Shareholders lost everywhere. Bonuses were paid everywhere.

When you turn up for a job interview at an investment bank there is only one real answer to the question “why do you want to work here?” but it is rarely answered truthfully. While bankers will give many grand reasons as to why they do the job, they are driven by nothing else but money. Money is everything.

I once arrived at an interview to be told the head of derivatives was going to conduct the meeting in his Bugatti on the way home. When I met him, he told me he was driving to the hospital where his wife was having their first child. While speeding through London he talked mostly about himself and how much money he had been making. He was just one of the thousands of bankers who are obsessed with money – their money. Whether the bank makes money is a secondary consideration.

Often the banks themselves have no idea if they are making money or not. The regulation of derivatives has been so weak, and the speed of innovation of new products so fast, that it has left a void on the trading floor. Cowboy traders have been taking advantage of a flawed system, knowing there is almost no chance of anything coming back to hurt them. So long as the traders can make it look like they have made a profit, they get their bonuses. This is the financial equivalent of the Wild West, yet only those on the inside realise this.

When trading in complex credit products exploded into life a few years ago, a whole host of financial products were created, mostly with acronyms for names. These are the same products that went on to blow up investment banks around the world as the sub-prime crisis emerged.

In the early days, two big banks picked up that they had been dealing with each other on a regular basis in very large volumes. After a while they each inquired what the other was up to. Both thought they were making money on the trades – bank A was selling something to bank B, yet both banks reckoned they were making a profit on it.

So both banks booked a profit in their accounts, and both sets of traders got bonuses. You don’t need to be a genius to see the problem here. Ultimately, only one set of shareholders will benefit.

Five to 10 years down the line, a sharp-eyed accountant might be able to spot the problem, but that is unlikely. Every few years there is typically a market blow-up, and issues like this get conveniently washed away as overinflated assets are then deliberately marked down below their true value in preparation for the next boom. That’s the point in the cycle we have reached now.

Many senior managers have been as clueless as the outside world as to how to value these trades. They are simply sitting at the top of the pile, praying they have timed it well to enjoy a couple of good years and allow themselves the opportunity to cream off the mother of all bonuses.

Job protection is a career in itself. All these complex products are designed and controlled by complicated computer programs. It has been known for the analysts who build the valuation systems to add pages and pages of unnecessary computer code so as to conceal what is really happening.

The managers are unable to check their work and the end result is that the guy who built the system is the only one who knows how to work it.

It is wrong to think that all investment banks are the same. Some institutions have been getting to grips with these problems, others have not.

My old bank is far from unique. My exposure to Lehman came through credit insurance my bank had sold to investors. If Lehman defaulted on its bonds, we were one of the institutions that would be asked to pay up. Bizarrely, we held these positions as part of a strategy that was designed to reduce the damage we would suffer if one of our big clients were to go bust.

The problem I had spotted suggested that all of the bank’s derivative trades could be valued incorrectly. This was more than just a minor hitch. Nobody wanted to listen and nobody wanted to make a decision. I sent e-mails; nobody responded. I asked the chief executive to sign off on the strategy himself, but I never heard back from him. Most of the other banks accounted for these trades in the same way.

So I was not the only guy who came unstuck last September, thanks to Lehman’s collapse. That was the event that turned the credit crunch from a crisis into a disaster. When I arrived at work, they let me through the door as usual. I took the decision myself that enough was enough. I suggested to my boss that I be made redundant and that my team be spared.