Practical analysis for investment professionals
27 September 2011

The Ethical Lessons of Rogue Trading

As Albert Einstein famously said, “Insanity is doing the same thing over and over and expecting a different result.” This quote comes to mind in the wake of the drama that has unfolded at UBS, where 31-year-old trader Kweku Adoboli is alleged to have committed fraud and false accounting in an effort to hide rogue trades. Dating from as early as October 2008, these unauthorized trades have triggered a $2.3 billion loss and led to the resignation of the Swiss bank’s chief executive, Oswald Gruebel. It wasn’t all that long ago that Jérôme Kerviel, a trader at Société Générale, lost $6.7 billion on illicit trades—and it’s been less than two decades since Nick Leeson toppled Barings Bank by famously losing $1.4 billion on unauthorized derivatives trades. (Adoboli, coincidentally, has retained the same law firm that represented Leeson.)

Much of the hand-wringing about this latest episode of rogue trading has focused on regulatory gaps in European trading rules and the failure of UBS to detect the unauthorized trades. Beefing up surveillance and enforcement may be necessary responses to this latest crisis, but they are hardly sufficient. That’s because rogue trading is as much a failure of ethics as it is a failure of regulation and risk management.

So rather than ask why scandals like these continue to happen, the more appropriate question to ask is this: Why do managers—even at large, prestigious banks—permit an environment where unethical behavior seems to flourish just beneath the surface?

A number of academics have attempted to answer this question. In an April 2011 article in the Harvard Business Review titled “Ethical Breakdowns,” business school professors Max H. Bazerman and Ann E. Tenbrunsel, coauthors of Blind Spots: Why We Fail to Do What’s Right and What to Do about It, highlight five factors that can lead managers to overlook unethical behavior in their organizations:

  • Ill-conceived goals. Goals set to encourage positive behavior inadvertently reward bad behavior.
  • Motivated blindness. We may overlook bad behavior when it serves our own self-interest.
  • Indirect blindness. Unethical behavior is easier to overlook when it is carried out by a third party.
  • The slippery slope. Lapses in ethical standards are easy to miss if the standards erode slowly.
  • Overvaluing outcomes. When the ends are positive, the means are less likely to be scrutinized.

In light of these observations, what can be done to discourage rogue trading?

I draw two conclusions. First, financial institutions need to review and perhaps restructure their compensation systems so that ethical behavior, good judgment, and solid decision-making processes are rewarded, not just outcomes alone. Top managers need to ask themselves, “What type of behavior do we want our employees to exhibit, and how does our compensation/reward system encourage or motivate that behavior?”

Second, organizations must promote an internal culture that recognizes the role of situational influences. In a 2007 Financial Analysts Journal article titled “Ethical Decision Making: More Needed than Good Intentions,” University of Texas business school professor Robert Prentice points out that “the circumstances in which we find ourselves often (not always) have more to do with the decisions we make and actions we take than do our basic character traits.” In that sense, individuals who commit rogue trading are probably not “sinister business people with sinister intentions,” to borrow from the opening quotation in Prentice’s article. More likely, they are people who made bad decisions, lost their moral bearings, and got caught in a cycle that they did not know how to break.

Thankfully, as Prentice points out in his FAJ article, heroic acts—not just unethical or evil acts—are also generally performed by ordinary people. But instead of losing their way, these individuals exercise “vigilance, determination, self-reflection, and a little courage.” So if the actions of individual employees are a reflection of the environments fostered by their employers, as Prentice argues, then it is imperative that financial industry executives look not just at the regulatory and risk management lessons of this latest trading debacle, but also focus on the important task of creating, reinforcing, and rewarding behaviors and decision-making that contribute to an exemplary culture of ethics.


About the Author(s)
Michael McMillan, CFA

Michael McMillan, CFA, was director of ethics education at CFA Institute. Previously, he was a professor of accounting and finance at Johns Hopkins University’s Carey School of Business and George Washington University’s School of Business. Prior to his career in academia, McMillan was a securities analyst and portfolio manager at Bailard, Biehl, and Kaiser and at Merus Capital Management. He is a certified public accountant (CPA) and a chartered investment counselor (CIC). McMillan holds a BA from the University of Pennsylvania, an MBA from Stanford University, and a PhD in accounting and finance from George Washington University.

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