LSBM302 AB1 Case Study Allied Irish Banks E-Risk

LSBM302 AB1 Case Study Allied Irish Banks E-Risk
On February 6, 2002, Allied Irish Banks - Ireland's second-biggest bank - revealed that it was investigating an apparent currency fraud at its Baltimore-based subsidiary, Allfirst, perpetrated by a trader named John Rusnak. It soon became clear that the scale and nature of the losses would make the AIB/Allfirst story one of the biggest 'rogue trader' scandals since Nick Leeson brought down Barings bank in 1995.

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LSBM302 AB1 Case Study Allied Irish Banks E-Risk

LSBM302 AB1 Case Study Allied Irish Banks E-Risk February 6, 2002, Allied Irish Banks – Ireland’s second-biggest bank – revealed that it was investigating an apparent currency fraud at its Baltimore-based subsidiary, Allfirst, perpetrated by a trader named John Rusnak. It soon became clear that the scale and nature of the losses would make the AIB/Allfirst story one of the biggest ‘rogue trader’ scandals since Nick Leeson brought down Barings bank in 1995.

LSBM302 AB1 Case Study Allied Irish Banks E-RiskThe AIB board of directors quickly commissioned an independent report into what had gone wrong. Written by Eugene Ludwig, a former US Comptroller of the Currency, the report concluded that Rusnak had systematically falsified bank records and documents, and been able to circumvent the “weak control environment” at Allfirst’s treasury.

Ludwig was given a limited period to carry out enquiries, and his report begins with the caveat: “We have emphasised from the outset that we believed that 30 days was inadequate to render a comprehensive report.” The investigators also had no opportunity to speak with Rusnak and the report does not necessarily reflect Rusnak’s understanding of events. But the report’s central finding was that AIB’s rogue trader had allegedly accrued losses by writing non-existent options and booking the fictitious premiums from them as revenue.

This, the report said, was in turn motivated by Rusnak’s need to recoup money he had lost on a misplaced proprietary trading strategy sometime in 1997. He later compounded the situation by selling a number of real deep-in-the-money options to counterparties for high premiums, racking up huge unrecorded liabilities for the bank. Estimates of the total losses to AIB/Allfirst from the debacle now stand at around $691 million.

While the bank’s solvency was not threatened in the immediate aftermath of the losses’ discovery – the bank was able to absorb the losses by a one-time charge on earnings – the loss was large enough to wipe out 60 per cent of AIB’s 2001 earnings and significantly deplete its capital. No senior AIB official was forced to resign over the affair, but the scandal badly dented the bank’s reputation and those of some senior executives. Many commentators predict that ultimately, the debacle may result in a takeover of the weakened bank by another institution.

The case also led many observers to wonder why, seven years after the collapse of Barings, the risk management lessons of the case were apparently having to be learnt all over again – in particular, the need for robust supervision of trading activity by back-office staff and risk managers, and for parent firms to be intimately aware of what is taking place at overseas units.

Meanwhile, Rusnak – by all accounts an unexceptional individual, living quietly with his family in the suburbs of Baltimore – has joined the likes of Barings’ Nick Leeson and Daiwa’s Toshihide Iguchi in the pantheon of rogue traders. And bank risk managers, who had begun to think of errant traders as a phenomenon of the past, are having to face up to the fact that a new generation of rogues may still be able to evade risk controls, including such industry standards as value-at-risk.

Lessons learned

Some of the lessons are strikingly similar to those of other rogue trader cases, such as Barings: lack of clear reporting lines, inadequate supervision of employees and failure to control fully the business that an overseas office was engaged in. Some key risk management lessons from the case include:

LSBM302 AB1 Case Study Allied Irish Banks E-Risk

Proprietary trading is a high-risk activity – and it is not just a question of market risk. A relatively small outfit without access to the information, expertise and economies of scale of much larger financial institutions may find it difficult to manage and control a proprietary trading business effectively. The potential operational risks may outweigh the potential market returns, perhaps greatly.

Risk management architecture is crucial – The Ludwig report concluded that risk management structure and practices within Allfirst’s currency trading operations were seriously flawed. As described in an ERisk commentary earlier this year, the operational risks that this implies can quickly transform the typically large market risk exposures incurred in a proprietary trading environment into hard losses.

The relationship between parent company and overseas units needs to be clear – From the Ludwig Report: “We think it is enormously important that there is unambiguous accountability.” In some areas, it was not clear who was accountable to whom, and the reporting lines within Allfirst and between Allfirst and AIB were blurred.

Strong and enforceable back-office controls are essential – Unlike Barings’ Singapore unit, there were independent back-office staff overseeing Rusnak’s activities. But the Ludwig Report says that Rusnak was able to persuade back-office staff to let normal procedures slip. Back-office staff must be empowered to stand by their guns if they have concerns about trading activity.

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