The Necessity of Stronger Internal Controls

The Necessity of Stronger Internal Controls- When are companies going to learn the detrimental effect of inadequate controls?

Once again UBS is in the headlines. Kweku Adoboli, a UBS trader was arrested and charged with fraud for unauthorized trading on September 15th.   Adoboli, a rogue trader, lost UBS 2 billion dollars.  The estimated $2 billion losses would list the UBS scandal among the world’s biggest rogue trading frauds. The sad part about it is that supposedly it was not UBS that detected the incident, but the employer himself that informed his colleagues of his actions.


UBS had minimal comments on the incident.  On their website of September 15th the media release stated, "UBS has discovered a loss due to unauthorized trading by a trader in its Investment Bank. The matter is still being investigated, but UBS's current estimate of the loss on the trades is in the range of USD 2 billion. It is possible that this could lead UBS to report a loss for the third quarter of 2011. No client positions were affected." The unauthorized trading is called "Rogue trading."  It is when an employee is making unauthorized trades on behalf of his employer. Banks encourage proprietary trading (usually within limits) and give traders bonuses for the amount of profit they make for the bank which provides an incentive to take risky bets. The problem is that this incentive can become even stronger if the trader made a bad bet and has big unreported loss.

Technically, they are not allowed to take big risk.  The banks require traders to remain within certain risk limits. What are the limits imposed on UBS traders?  What are the penalties for exceeding these limits?  What are the methods for detecting limits exceeded?   Aside from the limits, the trader is also supposed to log in all his trades by the end of each day.  Obviously if there are no mandatory procedures to follow or no one actually performing a check on daily transactions, the trader would attempt to hide huge losses hoping that it can turn around.  That logic prompts the trader to take riskier bets, which inevitably compounds his losses.

You would think that since a trader has opportunity to speculate that a bank would diligently employ internal controls.  Internal controls come at a cost, but the bigger costs can come when the internal controls are not implemented.

This incident will cost UBS and the banking industry their reputation which has been under scrutiny since the financial crisis. Customers and investors will lose any confidence they acquired toward the industry, especially toward UBS.  As a result of this incident, UBS is also likely to report a net loss in the third quarter.  In a time of economic crisis, how does a company like UBS permit such tarnish to the banking industry, I do say permit, because if adequate controls were employed 2 billion dollars in unauthorized losses would not exist.

In addition to their reputation and probable third quarter lose, the ratings agency Moody's placed UBS's credit grade on review for possible downgrade because of concern about the  future of its London-based investment unit.

Last month UBS announced 3,500 job losses due to poor trading figures. These job losses were estimated to save the company 2 billion dollars.  This rogue trader eliminated the savings to UBS.

This is not the first rogue trading scandal and it probably won't be the last but the bank’s credibility to customers could be at stake if it is found that internal controls were too weak to spot huge losses on its own accounts.  When are companies going to learn the detrimental effects of inadequate internal controls?  When are companies going to learn that it is worth to allocate sufficient funds for internal auditing and utilize their expertise and suggestions?