Australia's largest bank, National Australia Bank (NAB), lost hundreds of millions of dollars in speculative currency trading. The scandal broke out in January 2004 when a fellow trader working in the Melbourne office of the bank exposed unauthorized foreign currency derivatives trading. Initial reports had indicated that the total loss could be as high as A$600 million but Australian Prudential Regulation Authority (APRA), country's banking regulatory body, found that the currency trading scandal has cost the bank A$360 million.

In its detailed report on the scandal released on March 24, 2004, APRA found that the board of the National Australia Bank had been lax in regulation and supervision of currency risk management system. In its report, APRA recommended 75 improvements to restore confidence in the bank. These improvements include closing down of foreign currency options operations of NAB and increasing capital reserves by A$700 million until new trading limits and better risk management controls are put into action. APRA has also recommended that NAB should increase its capital adequacy reserves ratio to 10 per cent, which stood at 9.7 per cent at the end of September 2003.



The findings of APRA are consistent with an independent review into the scandal by accountancy firm PricewaterhouseCoopers (PwC). The PwC review had also found that the currency traders had exploited loopholes and weaknesses in the NAB’s system to hide trading losses. Although the scandal was uncovered in January 2004, the PwC review found that currency traders were concealing losses for several months.

With a market capitalization of A$45.8 billion, NAB is the largest stock in the Australian financial markets. The revelation that the NAB had lost hundreds of millions of dollars on unauthorized currency trading sent shockwaves to the financial markets. The scandal wiped out almost A$2 billion from bank’s market capitalization within few days.

Undeniably, the currency scandal has severely dented the reputation of the NAB but this is not the first time that the bank has been hit by a scandal and suffered huge losses due to poor risk management controls. In 2001, NAB had to write down A$3.6 billion from the purchase of US mortgage business, HomeSide. Millions of dollars were also lost in a fraud when NAB lent money to buy fictitious coaches. In fact, just six months before the latest currency trading scandal, APRA had cautioned senior management of NAB about its lax approach towards risk management systems in currency trading.

In the aftermath of scandal, several senior staff members of NAB have lost their jobs and the board has been restructured. The so-called “rogue traders” — Luke Duffy, David Bullen and Vince Ficarra in Melbourne and Gianni Gray in London — have been dismissed and are under investigation by the Australian Federal Police. While NAB Chairman Charles Allen and Chief Executive Frank Cicutto have resigned.

The currency trading scandal at NAB was the result of a combination of factors including greed, arrogance and lax regulatory and supervisory framework. In October 2003, “rogue traders” at NAB were trading highly leveraged call options on the Australian and New Zealand dollar in the anticipation that these currencies would fall against the US dollar. But their speculative bets were wide of the mark. Instead of falling, Australian and New Zealand dollar rose substantially against the US dollar between October and December 2003. With these currencies gaining strength, the currency traders at the NAB were losing millions of dollars every day.  If “rogue traders” had closed positions as the market moved against them, the losses would have been minimal. Instead, they doubled their bets in order to recover initial losses. Taking advantage of loopholes and weaknesses in the bank's system, they also entered fictitious currency transactions in the books to cover up their losses.



What is astonishing is that fictitious currency transactions and breach of trading limits went unnoticed for months at the NAB despite a plethora of internal checks and balances. It was only on January 9 2004, when a fellow trader noticed discrepancies in trading accounts and alerted the management. At that time, “rogue traders” had incurred a loss of A$185 million. Two weeks later when the entire currency portfolio of the bank was restructured, the total losses increased to A$360 million.



To some extent, blame lies with the behavior of four “rogue traders” at the NAB who were known for their aggressive approach in currency trading. All in their early 30s, “rogue traders” were so consumed by “profit is king” culture at the NAB that they overlooked warning signals. The year-end bonuses from currency trading gave them additional incentives to conceal losses and create illusionary profits through fictitious trading. Despite highly paid, currency traders earn more money through bonuses. The four “rogue traders” each received bonuses between A$120000 and A$265000 for the financial year 2002-03, almost double their annual salary. Gary Dillon, the bank's global head of foreign exchange, received a bonus of A$500000 last year on top of a hefty salary.



Although much attention has been paid in the media about the role of four “rogue traders” in perpetuating fraud at the NAB, but several important contributory factors have been largely ignored. To a large extent, lax regulation and supervision at the NAB provided conducive environment for “rogue traders” to carry out huge speculative bets on currency derivatives. It is difficult to believe that “rogue traders” were trading beyond their daily limits without the tacit approval from the higher authorities at the NAB. As per media reports, “rogue traders” had breached trading limits on as many as 800 occasions in the year 2003 and, at one stage, had an unhedged foreign exchange exposure of more than A$2 billion. It is implausible that senior management at the NAB was unaware of non-compliance of daily Value at Risk (VaR) limits and other standards by traders.



On the contrary, senior management at the NAB ignored the violation of trading limits and other standards since “rogue traders” were generating handsome profits for the bank through speculative bets in currency markets. In the words of David Bullen, one of the four traders, “We were over the limits and they were being signed off on a daily basis...so my boss was aware, his boss was aware and then other areas of the bank were aware of this type of thing. You know, it's not like, you know, [you] can hide limits and stuff like that from the rest of the bank…All they [senior management] ever really wanted was for money to be made, and the way that came about was secondary.”



It is also difficult to believe that fictitious transactions went unnoticed by the back office of the bank for almost three months. When a currency transaction is completed in the trading room, it is passed to the back office of the bank for recording. Confirmation of the transaction also comes from outside the bank, from the counterparties of the transaction. The agreed transaction is then entered into the bank's accounting system. It is inconceivable that the counterparties did not inform the back office of NAB about their transactions for almost three months. All these developments corroborate the contention that the scandal is not limited to only four “rogue traders” and back office of the NAB is equally involved in it.



It is evident that some of the lessons from earlier derivative scandals have not been learnt. One of the main lessons learnt from the Barings scandal was the need for complete separation and autonomy between the trading room and the back office of the bank. But in the case of NAB scandal, we have seen how back office fully connived with the trading room.



This scandal has busted several myths associated with the risk management systems of banking sector. First, banks and financial institutions do not have better governance and risk management systems than the non-financial corporate sector. Second, technical solutions and models (e.g., VaR), howsoever sophisticated these may be, are of little help in preventing the financial fraud.



The NAB scandal also reflects the growing dependency among banks and financial institutions on currency speculation and other risky businesses to reap higher profits. As deregulation and rampant competition from foreign banks have eroded their profits, banks are increasingly resorting to speculative activities in currency markets. Banks are the biggest players in the global currency trading. The global currency market is the largest market in the world. Since the breakdown on Bretton Woods system in the early 1970s, currency trading has increased manifold. Nowadays, over US$1.2 trillion is traded on an average every single day in global currency markets, whereas in 1977, the daily turnover was just $18 billion.



Since foreign exchange markets are extremely volatile and pose a systemic risk, their phenomenal rise has been a matter of serious concern. According to the Bank of International Settlement (BIS), daily spot transactions have declined over the years but currency trading through derivative instruments has witnessed a dramatic increase. Unlike spot transactions, currency derivatives (e.g., currency options, currency futures and currency swaps) are less transparent. Moreover, trading in currency derivatives is not only restricted to banks and financial institutions. Recent evidence suggests that non-financial institutions and transnational corporations are increasingly trading in currency derivatives. It is generally claimed that transnational corporations indulge in currency derivatives to protect their overseas businesses from foreign exchange risk but the possibilities of misusing currency derivatives to book speculative profits cannot be denied.



Although derivatives are supposed to help in reducing risk, they have become one of the biggest sources of volatility and instability in the global financial markets. Warren Buffett, the world's greatest stock market investor, recently described derivatives as financial weapons of mass destruction. In the Annual Report of Berkshire Hathaway (2002), Buffett stated “We view them [derivatives] as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Since derivatives are highly leveraged instruments, a small fluctuation in prices and exchange rates can cause huge losses to parties involved in such transactions and thereby pose systemic risk. We have seen how the collapse of massive hedge fund Long-Term Credit Management (LTCM) in 1998 had almost brought the global financial system to its knees.



In global currency markets where the risks and rewards are astronomical, the possibilities of frauds are also enormous. No wonder, the world is increasingly witnessing a series of currency trading scandals. Some scandals have come out in the open while others remain buried. Two recent scandals involving banks are cited here. In 2002, AllFirst Financial, a subsidiary of Allied Irish Bank — Ireland's second largest bank — lost US$750 million on foreign currency options trading when its trader, John Rusnak, systematically falsified bank records and documents to hide losses from speculative bets. Rijecka Banka — Croatia’s third largest bank — lost US$100 million (nearly three-quarters of the bank’s capital) in March 2002 when its currency dealer, Eduard Nodilo, indulged in unauthorized foreign exchange trading to hide past losses. In the aftermath of this scandal, the German bank, Bayerische Landesbank, sold its 59 per cent share in Rijecka Banka to the government for a symbolic price of US$1. The growing list of currency trading scandals calls for greater regulation of banks involved in currency trading, particularly currency derivatives.



To sum up, the NAB currency trading scandal not only demonstrates that very little has changed in the past one decade, but also raises fears of recurrence of it if policy makers remain oblivious of their responsibility to regulate banks as well as global currency markets.