The name is Kweku Adoboli. He works—or rather, worked—at UBS, Switzerland's largest bank. He's the guy UBS executives say made unauthorized investment trades that cost the bank $2.3 billion—enough to wipe out much of the bank's profit for the entire quarter.

 If the charges prove true, we can add Adoboli's name to the likes of such infamous “rogue traders” as Jerome Kerviel, who cost Societe Generale about $7 billion; Nicholas Leeson, who lost more than $1 billion, enough to bring down Bearings Bank; and Joseph Jett, who reportedly cost Kidder, Peabody $350 million, a hefty sum back in 1994. They're the best known, but hardly the only ones on the list.

Adoboli, 32 years old, was director of exchange traded funds (ETFs) in the European equities division at UBS, working on the bank's noted Delta One desk in London. Delta One desks are an important profit center for the big investment banks. When performing well, Delta One desks—which generally trade on small differences in the price of stock indexes and index futures—are highly profitable, with sound hedges created to avoid too much speculation and related excessive risk.

So what could go wrong? Well, plenty, and plenty did in the UBS case. It's important to recognize, as a backdrop, industry-wide proprietary trading generates huge profits, and Delta One desks operate on the edge, where market-making for clients can morph into proprietary trading; if the amounts or timing of hedges don't work, the bank's assets can be at risk.

UBS's top executives appeared shocked at what had happened. Before he resigned, CEO Oswald Gruebel said: “I am responsible for everything that happens in the bank. But if you ask me whether I feel guilty, I say ‘no.'” But he wasn't done deflecting blame. “If someone acts in a criminal way, there's nothing you can do,” he added. The underlying messages are that what happened at UBS was impossible to anticipate, and certainly could not have been prevented.

In addition to an investigation by regulators, an internal investigation has begun, of course, but some shareholders are up in arms that UBS put the chairman of its internal risk committee in charge. How, they ask, can a review be objective when led by the chairman of the risk committee that presided over the alleged failure?

The fallout from the UBS scandal has been widespread. In Switzerland the industry seems to have dodged a bullet, at least for now, when Parliament narrowly rejected an outright ban of investment banking; it is still considering increasing capital requirements for large banks to avoid the need for another bailout of UBS like the one that occurred in 2008. And Swiss politicians already are using the scandal to demand separation of UBS's private banking and investment banking operations.

Governments outside of Switzerland, including the United States, also are more likely to move forward with regulations such as the Volcker Rule, which would ban or limit proprietary trading by investment banks. For example, Britain has proposed a requirement that banks “ring fence” investment banking from consumer banking. European regulators are also considering how to strengthen trading rules, and the European Commission is expected to propose a new framework next month dealing with market transparency in exchange traded funds (ETFs)—almost certainly to be influenced by the UBS fiasco.

What Went Wrong at UBS

Until the internal and external investigations are completed and reported, we won't know with certainty how Adoboli pulled off the unauthorized trades. But it already seems clear that what he did involved placing unhedged bets on stock-index futures. Reports say he traded index futures and hid the trades by entering fictitious positions that kept the transactions within the bank's risk-exposure limits. That is, the unhedged positions were “offset” with fictitious, forward-settling positions in ETFs.

So, Adoboli was placing bets without the related offsetting trades, entering phantom trades to hide that he was speculating with the bank's money. He might have known about rules on how ETFs are settled, where a gap in reporting may have contributed to a breakdown in the paper or electronic trail that would reconcile cash and trading flows at the bank.

Whatever changes are forthcoming—including policy, process, technology, and related system modifications—they're not likely to be sufficiently effective without attacking the bank's cultural problems.

It's been noted that ETF trading in Europe is more opaque because most trades don't take place on a public exchange, but rather over-the-counter or in bilateral trades between investors, with limited reporting. And “internal futures” may have been used, where trades in other parts of the bank don't require confirmations, or at least not until future settlement dates. But one wonders why such trades wouldn't have been recognized as fake when cash failed to come in on the settlement date.

In any event, it's reasonable to ask why other controls weren't in place to quickly identify the fake trades, including why an absence of confirmations from counterparties to the trades didn't raise a red flag. Other questions raised by industry observers include: Why didn't margin calls, that would likely have been associated with such large futures trades, ring alarm bells? And how could UBS allow itself to become exposed to such a large—albeit fake—counter-party credit risk? A core issue relates to UBS saying the “unhedged” futures position violated its risk limits, but that suggests the bank tracks its risk positions on a net basis, whereas using a gross basis is known to provide more effective control.

As to how the trades were caught, controllers were making routine checks and questioned positions due to settle shortly, and the scheme was exposed. But if the fraudulent transactions were caught with such routine checks, why weren't they caught when the improper trading began three years ago?

The UBS Culture

We can't properly discuss what happened without looking at the bank's culture, evidenced by a string of recent troubles. These go beyond the well-publicized scandal helping wealthy Americans evade U.S. taxes, to include huge subprime losses and bailout by the Swiss government, charges by the N.Y. State Attorney General of misrepresenting securities risks to customers, and bid rigging in the municipal securities derivatives market.  Particularly telling is that when a U.K. regulator reported that a senior UBS manager in London failed to have adequate controls to manage risks, supervise employees, and otherwise prevent unauthorized trades, the manager was transferred to Zurich where he was assigned to risk management.

One former investment banker familiar with UBS culture pointed to how the bank stressed individual advancement over team efforts. “The problem isn't the culture, [but that] there wasn't any culture. There are silos. Everyone is separate. People cut their own deals, and it's every man for himself. A lot of people made a lot of money that way, and it fueled jealousies and efforts to get ever better deals. People thought of themselves first, and then maybe the bank, if they thought about it at all,” he said.

Critical Overarching Lessons

Listening to what UBS executives say has been fascinating—that they were “flabbergasted” for such a “meteorite strike,” and “if someone acts in a criminal way, there's nothing you can do.” These comments are eerily similar to what the chief of Societe Generale said after learning of Jerome Kerviel's unauthorized trading. Reality is that the risks of unauthorized trading are well known within the banking industry—and within UBS itself—and are preventable or certainly detectable on a timely basis before excessive damage is done.

So, one overriding lesson is that the risks need to be identified, analyzed, and acted upon to reduce residual risk to acceptable levels.

Another lesson stems from a recent UBS statement: “We have now covered the risk resulting from the unauthorized trading, and the equities business is again operating normally within its previously defined risk limits.” Well, it's difficult (if not impossible) to understand how any financial institution of that size, within a few weeks of finding such a multi-billion dollar fiasco, could possibly have identified the problem and instituted appropriate system and control modifications. It just doesn't work that way.

Whatever changes are forthcoming—including policy, process, technology, and related system modifications—they're not likely to be sufficiently effective without attacking the bank's cultural problems. And as we know, changing culture is like turning a battleship; it takes time. But change can be done, with a clear map of where senior management and the board want the bank to go and how to get there, along with commitment, energy, perseverance, and resources.

With risk management and related risk responses and controls, it's necessary to consider cost benefit. But what this means can be confused. A skeptic might say that the bank has made much more at its Delta One desk than the $2.3 billion loss, so what's the problem? Cost benefit, however, relates the cost of risk responses to a potential loss, and there's little question that the cost of adequate systems and controls pale in comparison to the loss incurred. Who is to say that the loss couldn't have been multiples of what it turned out to be; we recognize that it's not the actual loss that drives action, but the risk of what could happen. And of course there are legal and regulatory compliance requirements that are non-negotiable and must be addressed.

We know Adoboli is called a “rogue” trader, with all the associated implications of one person acting alone whose actions couldn't have been prevented. But we know better. We know the risks, and what needs to be done to manage them to reasonable levels. It's a case of learning the lessons, hopefully once and for all, and doing what's needed to avoid more such “rogues.” Based on history, however, we'll need to save more room in the rogues gallery for what the future is likely to hold.