Allfirst Financial: Out of Control

 
 
By Sean Gallagher  |  Posted 2002-03-12
 
 
 

Baltimore's Mount Washington neighborhood is not a likely locale for an international banking scandal. But the narrow streets of this hilly upper-middle class enclave were jammed in the first week of February with TV remote trucks and British tabloid journalists standing vigil around one $232,020 home. The hope: John Rusnak, a currency trader at Baltimore's Allfirst Financial, would pop out of his hole like Punxsutawney Phil had four days earlier to see his shadow.

PDF Download But Rusnak wasn't at home. Nor, for that matter, was $691 million that was supposed to be in Allfirst's treasury. And the bank faced a lot more than six additional weeks of winter.

Even though Allfirst, the U.S. unit of Ireland's Allied Irish Banks (AIB), should have been able to prevent or flag unauthorized trading of this magnitude, it didn't. And the damage from bogus trades and secret accounts that Rusnak appears to have created is tangible. In a recent filing with the Securities and Exchange Commission, Allfirst warned it will have to re-submit annual financial statements going back to 1997. The loss effectively wipes out the company's net income for the past four years.

At the heart of the problem was the bank's system of currency trading controls. "It's very clear now that this guy targeted every control point of the system and systematically found ways around them, and built a web of concealment that was very sophisticated," AIB CEO Michael Buckley told reporters while discussing Allfirst's loss.

Allfirst won't say why they failed to detect such a long-running scam. But in this case, a single trader should not have been able to put more than $2.5 million of the bank's capital at risk. And if all trading had been electronic, no individual should have been able to hide losses.

The debacle is proof the global marketplace isn't electronic from end to end. And while AIB has deployed software that effectively tracks and controls the actions of its traders in its own offices around the world, Allfirst had implemented only a portion of that system. Not yet installed, for instance, is a program that would capture the specifics of currency trades electronically, and, one that would manage the confirmation of electronic trades, once executed. With only two employees including Rusnak on the currency-trading desk, Allfirst apparently didn't think the expense of full integration was warranted. And, AIB appears to have been happy with Allfirst's results.

In the company's annual financial statement for 2000, Allfirst crowed:

Trading income, before the effect of the cost to carry derivative assets on the balance sheet, increased by $6.6 million, due to growth in foreign exchange trading activities. Trading income (net of the cost to carry derivative assets) was $10.9 million in 2000 and $9.8 million in 1999.

That $10.9 million would have been the equivalent of 6% of Allfirst's net income for 2000. This, with a trading desk of two people.

Which seems to show Rusnak wasn't out to bankrupt his employer—he was out to make Allfirst a lot of money by taking big risks on the relationship between the values of the dollar and the Japanese yen, according to AIB executives.

Trading of currencies is broken down into two functional areas, the "front office" and "back office." The front office is the trading desk itself, where trades are made and recorded. The back office handles accounting and oversight—the confirmation of validity of trades, enforcement of internal controls (such as trading credit limits), the matching of trades with confirmations from the counter-parties (who the trade was executed with), trade fulfillment, and passing data on the positions taken by traders to managers and risk analysts.

This separation of responsibilities is key to the control of trades. When the two functions are blurred, the opportunity for a trader to "go rogue" rises exponentially. The greatest example: the 1995 case of Barings Bank. There, a single trader, Nicholas Leeson, lost nearly all the assets of the bank, amounting to $1.2 billion. "It was established after the fact that he had control over back office," says John Harvey, a managing principal at Capco, a financial systems consulting firm in New York. "The initial cause of [the Barings disaster] was due to lack of segregation."

Skipping Safeguards

In theory, the segregation could have been achieved in software AIB already had. In 1998, AIB began to install a software suite from Misys, based in the United Kingdom, at offices in Dublin, London and New York. In the back office, Misys' Opics program centralized many functions, including the tracking of foreign exchange transactions. At the trading desk, AIB installed Tropics, a software package for capturing currency trades electronically.

These two products can be directly integrated, providing what in the trading world is called "straight-through processing"—computerized handling that allows trades to be fulfilled on the same day they are authorized.

"It's a fairly durable system," says Debbie Williams, co-founder and research director at Boston-based Meridien Research. "[Opics] is a pretty typical trading system, and very secure if you're using their front end."

According to an article in International Banking Systems in November 2000, AIB was one of the first banks to roll out Opics. And the bank planned to deploy Opics at its subsidiary, Allfirst. But apparently, it didn't install the front-office Tropics software there. Many processes, such as matching trades, continued to be handled manually.

Misys declined to discuss the case. "We don't have anything to add to this story," says Jeff Clark, Misys' U.S. marketing manager, from his office in White Plains, N.Y. Sean Fitzgerald, managing director of foreign exchange activities at Allfirst, refused to comment on the bank's trading systems. "I'm not at liberty to discuss that," he says.

Nonetheless, such software, if in place, could have prevented transactions that didn't have bona fide sellers and buyers. Without it, trades could be faked at the trading desk and not caught on the back end. "If trade information was hidden, or if bogus trades were entered, it would have most likely happened at the front-office end," says Harvey.

Good controls should prevent excessive trading. One function of front-office software is to generate alerts when a trading credit limit is exceeded. Warnings can be sent automatically, by e-mail or page, to the appropriate manager.

The back-office software also generates formal reports on such exceptions. So, even if managers at Allfirst weren't immediately aware of trades by Rusnak that went over his $2.5 million trading limit, they should have become aware of them when reviewing daily and weekly trading reports. Apparently, experts say, they either never noticed the patterns or simply ignored them because they trusted Rusnak's judgment.

In addition, Allfirst should have had in place a system that ensures all trades are between valid parties. But another element used by AIB's larger currency trading operations that was not used at Allfirst was an electronic trade confirmation management system.

When a trade is made, the two parties involved are supposed to exchange confirmations, to legally acknowledge the transaction. For a trade to be valid, there must be matching confirmations. Parent AIB uses the Crossmar Matching Service, an automated matching service that can confirm trades within two minutes.

Allfirst didn't use Crossmar. According to industry experts familiar with Allfirst, it handled most confirmations by fax. And in manual confirmations, it's not unusual for confirmations to go unmatched for some time.

"Bogus trades would have lacked confirmations from counter-parties," says Capco's Harvey. Without active matching of confirmations, Rusnak would have been able to enter nonexistent trades for currency options that would have countered the effect of his bad trades, essentially reducing the apparent risk to zero from the point of view of a risk manager.

The types of trades Rusnak was engaged in required even more oversight than straight currency trades. AIB confirmed that some of the trades were "forwards," or option trades based on the idea that currency rates will swing into one's favor at a future date, when the trade will be completed.

Risk Management MIA

Yet another piece of AIB's standard currency trading system was missing from the Allfirst equation—its risk-management analytics software.

Back-office and front-office systems feed data into risk analysis software, so that a company's losses on trading positions and investments are minimized. By calculating the risk on known trades, a firm can cover its risks with countervailing trades in currency options and derivatives.

In 1998, AIB started installing Askari's RiskBook software to perform this function; Askari has since been acquired by financial services company State Street Corp., and the product is now marketed under the name TruView.

Allfirst apparently was not part of the RiskBook rollout. Instead, the bank was using somewhat less sophisticated software for risk management. The company holds licenses for desktop-based software from MB Risk Management, a risk management consultancy in the U.K., according to that company. Allied, though, will not confirm whether that software was being used by Allfirst recently.

According to a recent report in Institutional Investor Newsletters' Derivatives Week, Rusnak himself was seeking new risk management software for Allfirst a year ago but didn't complete the purchase because of budget constraints.

The missing software wasn't fatal by itself—but it magnified deeper problems in Allfirst's operation: the ability for a motivated human being to take advantage of weaknesses in its systems. "Clearly there's a human element in the breakdown of procedures," says Harvey.

Despite the company's contention that no one was aware anything was wrong with Rusnak's trading positions until late last year, outside experts expect co-workers or managers had a clue something was going on.

"These things don't happen in isolation," says Williams. "There were other people sitting on that desk who knew what he was doing. These guys are such braggers, usually."

Indeed, Rusnak may have relied on his closeness to others within the Baltimore office of Allfirst to hide how big a risk he was actually taking.

"There were only two individuals managing this derivative portfolio," says Haluk Unal, a visiting scholar at the Federal Deposit Insurance Corp. and a professor at the University of Maryland's R.H. Smith School of Business. "It was a very close, tight operation."

AIB plans to release the results of its internal investigation sometime in March. However, the bank has already ceased currency trading operations in Baltimore. There are no signs they will ever resume.

Allfirst Financial Base Case

Headquarters: 25 South Charles St., Baltimore, MD 21201

Phone Number: (410) 244-4000

Business: Provides comprehensive corporate, commercial, correspondent and retail banking services, personal and corporate trust services in Mid-Atlantic states

Chief Information Officer: William G. Fitting, Senior Vice President, Operations and Processing Services

Financials, nine months 2001: $1.1 billion in revenue, $149.4 million in net income, net profit margin 14.1%

Challenge: To maintain and increase profitability in a competitive regional financial services marketplace

Baseline Goals:

  • Investigate loss of $691 million from unauthorized currency trading
  • Develop systems to prevent recurrence
  • Evaluate whether to resume ongoing currency trading, which generated as much as $10.9 million of annual profit