February 27, 2024

DealBook: UBS Scandal Is a Reminder About Why Dodd-Frank Came to Be

Kweku M. Adoboli of UBS was charged on Friday in London with one count of fraud and two counts of false accounting.Adrian Dennis/Agence France-Presse — Getty ImagesKweku M. Adoboli of UBS was charged on Friday in London with one count of fraud and two counts of false accounting.

Although the UBS trading scandal happened at the London office of a Swiss financial company, big American banks will feel regulatory heat.

When UBS revealed on Thursday that a rogue trader had lost a quantity of money so large that it potentially wiped out profits for the entire quarter, the case cast a glaring spotlight on banks’ risk-taking activities and evoked painful memories of the financial crisis. Such blowups had helped bring the system to the brink, forcing governments to bail out banks and prompting a global economic slowdown.

The timing is bad for banks.

In the coming weeks, policy makers are expected to propose new regulations intended to limit federally insured banks from making bets with their own money, according to a government official with knowledge of the process. The rules — part of the Dodd-Frank Act, the regulatory overhaul enacted in the wake of the crisis — take aim at a practice called proprietary trading, in which companies speculate for their own gains rather than for their customers’.

While the industry has been lobbying aggressively to temper those regulations, the rogue trading case could give proponents of the so-called Volcker Rule, which would prohibit proprietary trading, more ammunition. UBS, which stands to lose $2.3 billion on the unauthorized trades, said in its initial four-sentence announcement on the incident that “no client positions were affected.” The implication was that the trader was using company money to place his bets.

“As recent events have shown, banks’ trading operations have become too poorly policed,” said Senator Carl Levin, Democrat of Michigan, who introduced the ban on proprietary trading in Dodd-Frank along with Senator Jeff Merkley, Democrat of Oregon. The rules “will help prevent banks from making risky bets for their own accounts that could threaten the firm or our economy.”

As fodder for advocates of tough regulation, the UBS case is a somewhat ambiguous example. The London police have charged the trader at the center of the scandal, Kweku M. Adoboli, with fraud and false accounting.

If the accusations prove to be true, the Volcker Rule — named after Paul A. Volcker, the former Federal Reserve chairman — would not necessarily prevent the same situation from happening at an American bank. The regulations are intended to curtail speculative bets by a company, rather than stop the criminal acts of a single person.

“Compliance programs aren’t necessarily crime-detecting initiatives,” said Jaret Seiberg, a policy analyst at MF Global.

But the incident does raise questions about risky behavior at banks — and whether the companies have the appropriate systems and controls in place to monitor those activities. While the charges against Mr. Adoboli detail actions dating back to 2008, UBS did not discover any problems until recently.

The UBS scandal also brings into focus the fuzzy nature of proprietary trading.

Like many big Wall Street banks, UBS has shifted away from stand-alone desks that make bets with the bank’s money. Under the Volcker Rule, those “prop desks” would be banned at American companies and foreign companies that operate in the United States. (UBS would not be subject to the same rules in its London office, where the incident took place.)

But proprietary style trading still exists in groups that cater to corporations, hedge funds and other big institutions. Such units have become big profit centers for Wall Street banks like Goldman Sachs and Morgan Stanley.

Mr. Adoboli worked in one of those areas at UBS. As part of the Delta One desk, he helped develop trades for clients, focusing on exchange-traded funds. But he also took speculative bets on various benchmarks, including the Standard Poor’s 500-stock index, according to UBS. Those positions violated the firm’s risk limits, which he “concealed” by creating “fictitious trades,” the bank said.

A spokeswoman for Kingsley Napley, the law firm representing Mr. Adoboli, declined to comment. UBS declined to comment beyond its releases.

The Delta One desks operate in a gray area, where the line is sometimes blurred between proprietary trading and client activities like market making. A bank, for example, can buy securities from one customer with the intent of selling them to another client. But if the bank holds the assets too long or lets the stake grow too large, it may look more like a proprietary trade.

“You’re never going to be able to craft a rule that permits legitimate market-making activities that our economy desperately needs while at the same time prohibiting proprietary positions,” said Mr. Seiberg of MF Global. “That’s because one man’s market making is another man’s prop trading.”

Regulators are looking to make the boundaries clearer. After working on a draft of the Volcker Rule for weeks, they now agree on some of the thorniest provisions, including the definition of market making, according to a person with knowledge of the discussions.

But they are still debating how to enforce the regulation. While some are pushing for Wall Street to police itself in proprietary trading activity, the Federal Deposit Insurance Corporation and other policy makers want a tougher crackdown. The agencies could leave open the possibility of a compromise plan for banks to detail their positions to data warehouses, where regulators could keep an eye on the trading. They have also discussed whether to hold executives liable should a bank skirt the rules.

Under the proposal, the definition of market making, at least for now, largely tracks the metric laid out in an earlier report by the Financial Stability Oversight Council, according to the person close to the discussions. For example, positions held for less than 60 days would draw scrutiny, as regulators ensure that the trades are either bona fide hedges or market-making deals.

It is a tough rule to get just right. Make the regulation too broad and it could prove ineffective at keeping banks from taking on too much risk. Make it too specific, and it could crimp legitimate businesses that bolster the economy.

“The challenge for regulators is to thread that needle,” said Donald N. Lamson, a lawyer at Shearman Sterling and a former Treasury Department official who helped write the Volcker Rule. “You have to draw a line somewhere.”

Article source: http://feeds.nytimes.com/click.phdo?i=1bb9450607f7b02e6577c31e76c6c6a8

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