What will the branch manager say about this?

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The Independent Online
This is a bad, bad day for National Westminster Bank - worse, in some respects, than the time when Department of Trade and Industry inspectors were sent into NatWest to investigate the Blue Arrow affair. That management controls at any City bank could be so loose as to expose it to catastrophic loss on this scale is bad enough; that it should happen to a high street bank with a jealously guarded reputation for prudence and probity makes it seem doubly worse.

When rogue trading incidents of this type are confined to foreign or family-controlled specialist City banks, it certainly makes a good story but its wider impact is generally limited. Indeed the suspicion is that much of the time these episodes go entirely unreported; when the bank is a partnership and the losses not life-threatening, it is not hard to hide the incident in the general melange of complex derivative trading. The culpable traders are disciplined and fired (though not publicly), controls are tightened, and the ship sails on as before with few people outside the bank any the wiser. It could well be that these things are more common than generally thought.

But for it to happen to a retail bank is something else. What is the small town branch manager going to say after this when confronted with the customer with an unauthorised overdraft? Sorry mate, our City people may be able to get away with pounds 90m of deceit, but down here we operate to different laws. How is he going to explain bonuses, of more than pounds 1m in some cases, earned entirely on the back of bogus profits? How is he going to explain to his staff that a high street bank, a clearing bank for heaven's sake, could ever have contemplated these lottery-type payments in the first place? And how is he going to explain that the "mis-pricing" went on for more than two and a half years without anyone noticing it?

Sir Brian Pitman, chairman of Lloyds-TSB, always had a very obvious answer to the sort of position NatWest now finds itself in. The culture and underlying business of retail banking and investment banking are so different that they can never be made to mix, he insists, and any attempt to bind them together under one roof is ultimately doomed to failure. As a consequence, Lloyds has steered clear of investment banking, concentrating instead on building itself into one of the country's leading retail financial services groups.

NatWest has swung the other way, choosing to reinvest the money it realised by selling Bancorp in the US and Banco NatWest Espana, on bolt-on acquisitions for its investment banking offshoot, NatWest Markets. A key element of group strategy is to build NatWest Markets into a world-class player in international capital markets and securities. Today that strategy looks badly dented, if not quite ripped apart, and Sir Brian's view seems to have been entirely vindicated.

Does a clearing bank really have the management nous needed to control and run an investment bank? The skills, disciplines and systems are very different ones, as different, Sir Brian would say, as chalk and cheese. It would be an exaggeration to say that NatWest had it coming, that it is an innocent dabbling in a business where it was always likely to lose its shirt, but there may be an element of that here.

Furthermore, the whole sorry episode highlights in quite spectacular fashion what so many both inside and outside the City have been banging on about for so long now - the dangers in financial markets of very high levels of bonus-driven pay. The pounds 8m of bonuses that NatWest will not now be paying appears to have been promised to fewer than 10 people in the interest rate options trading activity where the mischief took place. If these bonuses were profit and success-related, as they almost certainly were, then there was clearly a very powerful incentive both to inflate profits artificially by mis-pricing the options and to construct an elaborate cover-up of what was going on.

NatWest claims not yet to know what the motivation was, if indeed there was any at all. That must ultimately await the judgement of regulators. But it's not hard to figure it out. What happened here plainly went beyond simple negligence and incompetence, as NatWest itself half admits in its statement.

The losses, it says, were obscured by mis-selling, and the transfer of value between books also made the losses and mis-pricing more difficult to detect. This is code for saying there was a deliberate deception. The fact that the Serious Fraud Office has been briefed adds to the suspicion that these were deliberate acts.

Can any organisation ever hope to stop the determined rotten apple? Well perhaps not in the early stages, but what makes this particular case so hard to understand is that it went unchecked for so long.

There are two possible explanations of why. First, interest rate options are quite complex derivative instruments, though not nearly as complex as some, and their pricing requires highly technical modelling. Few non- specialists understand it fully. The second is that these instruments are traded over the counter, so there are none of the usual safeguards and alarm systems that operate in transparent, regulated markets.

Options are customised products and their pricing is to some extent subjective. In this case the mis-pricing was achieved by feeding absurd interest rate volatility assumptions into the model. Whether you are inside or outside, it is hard to tell that this is happening. Since options are essentially private transactions, there's nobody to blow the whistle and point to the absurdity of the pricing as there generally is in more traditional financial markets. If steps are then taken further to obfuscate the position by transferring values between different books, it becomes even more difficult to see what's happening.

None of this should excuse NatWest's failure. Derivatives are sold on the basis that they allow organisations to reduce risk and hedge their exposure to particular market positions and securities. Investment banks make an awful lot of money designing and selling these instruments. But if they cannot control their own risk, who's going to believe that these products actually limit anybody else's?

The great fear is that the explosive growth of these instruments poses a special kind of threat to the financial system. It is not difficult to construct a doomsday scenario in which the world's financial system is brought to a grinding halt by a chain reaction of linked defaults. Fortunately the great interest rate options scandal has proved to be a quite confined episode. This was not the great derivative-triggered collapse that some alarmists think will one day rock financial markets. But that's fat comfort to Derek Wanless and his board at NatWest. They are now going to have to live with the embarrassment of being the first British clearer to fall victim to a derivatives scam.

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