It is no exaggeration to say that proper and appropriate trade surveillance could have helped to avert or reduce the impact of many of the events that banks have been paying for in the past few years. In Chapter 21, we explore new cognitive AI tools that can complement the current trade surveillance activities to identify risky behaviors before they result in losses and reputational damage.
Finally, we discuss external factors, in particular, the role of external stakeholders, from regulators to society at large. The level of interdependency between institutions was shown for all to see in 2008 and needs to be studied to understand how a reoccurrence of those types of events can be prevented. This may be critical in helping our banks and society to avoid a repeat of the 2008 Financial Crisis in the near future.
Acknowledgments
I could not have written this book without the many colleagues over the years from whom I have learned so much. There are too many to name, but you know who you are. Thank you!
I would also like to acknowledge the following who have helped me to bring this book to fruition: Dickie Steele, my fellow Bowdonian in New York who provided insights and ideas right up to the final deadline; Josh Getzler, who provided the initial encouragement in my writing endeavors; Steven Stansel at IBM Press who helped navigate the publishing pathways at IBM, and Bill Falloon and rest of the team at Wiley who provided such brilliant support throughout this process. Lastly, to my family – you're simply the best!
About the Author
Andrew Waxman is an associate partner in IBM's Financial Services Risk and Compliance consulting practice with over 20 years of experience, in the United States and the United Kingdom, helping financial services organizations manage complex business issues.
Andrew has written on risk and banking issues in journals such as American Banker and Wall Street and Technology for many years.
Andrew lives in New York, where he shares his home with his wife and two daughters.
CHAPTER 1
The Historical Context
Wall Street has changed immeasurably in the past several decades. Key changes that have occurred include computerization of trading, the growth of universal banks (and hedge funds), and the development of financial engineering. Each of these changes enabled major revolutions to take place in our larger society. Banks are not what they used to be, but while they were agents in enabling change in society – changes that brought major benefits – with these benefits also came major costs.
First, computerization of trading has helped to facilitate the growth of a shareholder society. The casual, retail investor now has access to trading tools that provide access to very liquid and fast‐moving markets with the ability to execute shorts, options, swaps, foreign exchange (FX), and other complex transactions from their PC or smart phone. The cost of participating in such trading activities has declined dramatically and, as a result, millions more people9 own shares today than in the past. This has been in large part due to the creation of new trading and computer technologies and resulting cost reduction. Such gains are not achieved without risk, however. Some of the operational risk incidents we will review in the coming chapters stem from the technical challenges that are posed by such technological advances.
Second, the growth of universal banks10 with massive capital resources and services aimed at every customer segment has helped achieve major efficiencies in the promotion of new capital structures and investment vehicles. The availability of credit to greater numbers of people and the provision of new types of financial innovation to every type of corporate entity has enabled the creation and expansion of new productive capacity in the United States. These advantages were particularly clear during the expansion years of the 1990s and early 2000s. However, these benefits also brought problems in their wake.
The sheer size of these universal banks and the stitching together of different legacy systems and bank cultures has created patchworks of manual process and controls that became too complex to manage. The risk of great and complex failures inherent in such unwieldy structures has, in the eyes of many analysts, grown, rather than retreated since the Financial Crisis of 2008. Most recently, Neel Kashkari, chief of the Federal Reserve Bank of Minneapolis, has argued for further controls to be put in place against banks that are so called “too big to fail.”11
To his point, managing multiple businesses and multiple country branches brings a level of complexity that makes it much more difficult to monitor activities across an entire organization. Additionally, privacy laws that have multiplied in different countries have further exacerbated this issue. This can and has led to failures to assert centralized controls and unified lines of defense against suspicious trading activity and the like.12
Third, the growth of financial engineering took place in the context of relatively light regulation and planning. Credit default swaps, for example, started as a relatively obscure product in an obscure trading group within investment banks. While investment banks and broker/dealers are required to oversee new product development in a careful way, new products have a habit of getting through with relatively little scrutiny and planning. This lack of planning is, in part, a reasonable response to the nature of the trading market. Many products are thought up in the twinkle of a trader's eye and many of them fail to take hold. In the case of credit default swaps,13 however, within a very short time frame, billions of them were being written to cover bondholders and non–bondholders. Expansion in areas like this brought much greater profits to the banks, at least for a time. It also brought much greater complexity to the business. Obscure products like credit default swaps can thus grow from a relative backwater status to a major profit center in a short space of time in a way that is hard to predict or plan for. The ability to manage the resulting complexity, however, does not tend to keep up. The rash of scandals, penalties, and significant operational losses in the case of mortgage‐securitized products are one indicator of that.
The rapid change at investment banks as a result of these particular areas of innovation has made it hard for regulators to keep up in their ability to understand and monitor these changes. Yet the role of regulators has never been more important. In some ways, the battle over regulation that took place in the years after the 2008 Financial Crisis, and in particular, the battle to introduce the Dodd‐Frank legislation was similar to that played out in the original battles fought by Washington and the SEC to establish US securities laws and the SEC in the 1930s. This will be discussed further in Chapter 22.
The battle fought by the regulators since 2008 has also been to arm themselves for battle more effectively, by adding to their ranks people with the expertise and experience to be able to identify, monitor, and manage the risks as they unfold at their charges' houses of operations. Unfortunately, it may always be the case that regulators, like the French generals of the 1930s who built the Maginot Line of Defense, are doomed to be forever fighting the previous war.
The example that perhaps best illustrates this is the case of Wells Fargo that hit the headlines in 2016.14 This was different from what had gone before in three important respects. First, relative to the mortgage and other scandals, which led to billions of dollars in lost wealth, the churning of unauthorized bank and other accounts involved sums that were relatively small. Second, instead of a few relatively high level traders being involved, as in, for example, the mortgage, FX and LIBOR scandals, this scandal involved thousands of fairly low level employees. Third, those involved in the scandal did not possess any special financial engineering