Introduction

On February 28, 1997, NatWest Markets (NWM), the corporate and investment banking arm of one of the UK's largest banks, National Westminster, revealed that a 50 million loss had been discovered in its interest rate options and swaptions trading books. The loss figure escalated to 90.5 million after further investigations.

NWMs troubles started with a systematic mispricing of various options and swaptions by traders in its rate risk management group. As losses mounted, Kyriacos Papouis, who traded Deutschemark (DEM) interest rate options and swaptions, began to mismark options positions in the banks books in a concerted attempt to cover up the losses. His supervisor, Neil Dodgson, who traded Sterling (GBP) interest rate options and swaptions, also mismarked positions and was later found to have lacked the due skill, care and diligence required of him by his regulators at the Securities and Futures Authority (SFA). (The SFA is now subsumed within the UKs Financial Services Authority, or FSA.)

The fallout was swift and substantial. Papouis, who had moved on to Bear Stearns, resigned from that position and a handful of senior managers at NWM, including Dodgson, also resigned or left the bank in the months after the losses were discovered. Investor and shareholder confidence in the management of NWM was severely shaken and, in June 1997, Martin Owen, the head of National Westminsters investment banking group, also resigned. Rightly or wrongly, confidence was shaken so badly that in July 1997, the Bank of England had to instruct NatWest to resist calls for the resignation of its most senior executives in an effort to draw a line under the affair.

The banks internal controls and risk management were questioned and severely criticised in May 2000, after a lengthy SFA investigation.

The regulator imposed a penalty of 420,000 on NWM, and fined and reprimanded Papouis and Dodgson for breaches of SFA principles. But the real damage was to perceptions of the quality of National Westminsters management, risk control and overall strategy. Some analysts feel that the losses in the capital markets small in relation to the size of the bank undermined confidence in National Westminster so badly that that they helped set the scene for the Royal Bank of Scotlands successful takeover bid in February 2000.

- Roles and responsibilities must be clearly delineated between the front, middle and back offices: failures in risk management are primarily failures in process.

- It doesn't take complex derivatives to get a firm into trouble. As with Barings Bank in 1995, NWM's saga began with losses from exchange-traded options.

- That said, relative to other financial assets, the valuation of options is peculiar in that a key metric the implied volatility of the underlying asset is unobservable. So best-practice risk management calls for independent verification of the pricing model, the data fed into the model, and the model outputs (eg, prices).

- Pricing that is consistently off-market is a warning flag that something in the risk management process is amiss.

- A communications strategy for managing public perceptions is vital. NWMs debacle might have been even worse without the banks prompt disclosure of the losses and the active and relatively open way in which it pursued its enquiries.

NatWest, like many other internationally active banks, had moved aggressively into investment banking in the 1990s. This meant building a presence in the rapidly growing derivatives markets. Papouis and Dodgson worked in the rate risk management area of NWM, where interest rate options and swaptions were traded on a number of underlying currencies.

Market observers suggested at the time that the root of NWMs problems lay in the aggressive pricing of interest rate options and swaptions. It remains unclear as to whether the initial mispricing was a conscious attempt to gain market share for the institution, or due to a misunderstanding of the structure of volatilities. (The SFA later concluded that the debacle as whole was not inspired by the pursuit of personal gain.)

The difference between competitive and risky pricing by traders is not always obvious to management in the options market. This is because one of the key parameters in the pricing of interest rate options and swaptions is the implied volatility of the underlying asset. (In the case of GBP interest rate options, for example, the underlying asset is GBP interest rates.) Implied volatility reflects the expectations of market participants about the volatility of the underlying over the term of the option. Unlike other factors that play into the valuation of an option (such as the strike price, the risk-free interest rate, the term, and the price of the underlying), the implied volatility of the underlying asset is unobservable it has to be estimated.

Yet the implied volatility of an underlying asset is also the key relative pricing metric by which options can be compared. So, to the extent that there is no right or transparent price for an option, there is a risk that an options valuation can be miscalculated or manipulated.

And theres an extra complication: classical models for pricing options assume that the implied volatility of any option on the same underlying asset is constant. Under this assumption, options of all terms and strike prices are priced using the same value for implied volatility. However, the assumption is belied by market observation. Out in the real world, implied volatilities tend to differ according to strike price (for any single expiry) and term (for any given strike price). Plotting these implied volatilities on a graph, against various strike prices, creates a profile known to options traders as the volatility smile. Traders and risk managers need to be aware of the smile and must incorporate it into their valuation of option portfolios.

Figure 1 illustrates the volatility smile. Lets assume that all of the options are on DEM interest rates, with the same expiry date. The figure shows the implied volatilities of options with strike prices ranging from 3 to 7 per cent. Clearly, the markets view is that implied volatilities are not constant for different strike prices.

One way to misprice such interest rate options is therefore to fail to make the prices offered consistent with the smile in the market. For example, imagine that a company failed to take the smile into account, and simply employed an average rate across all strikes. Recall that the value of an option is positively related to the estimate of its implied volatility. To the extent that out-of-the money volatilities were higher than at-the-money volatilities, the out-of-the-money options would be underpriced and the at-the-money options would be overpriced.

Its not entirely clear how Papouis made his initial mistakes in options pricing, but it is clear his losses mounted steadily as the markets moved away from his mispriced options portfolio. The SFA estimated that Papouiss losses escalated from 1.1 million in March of 1995 to 7.96 million in late June 1995, and to 22.4 million by late December 1995.

The relatively slow escalation of the losses shows that NWM had plenty of time in which to halt the traders actions. Furthermore, at this point, most of the losses were related to exchange-traded DEM options. These losses should have been relatively easy for NWMs back office to spot, given the discrepancy between any values in the banks systems and readily available market price data supplied by the exchange.

However, when in February 1996 a member of NWMs back-office staff belatedly pointed out the discrepancies between the exchange market prices and the prices recorded in the banks back-office systems, Papouis was simply told something had to be done about them.

According to the SFA investigation, Papouis solution was to attempt to conceal the losses in the DEM interest rate options by undertaking a series of off-market transactions between his DEM options portfolio and his swaptions portfolios. These made good the DEM options portfolio, where it was easy to see the losses, to the disadvantage of the DEM swaptions portfolio where losses were easier to conceal. The SFA report explained that Papouis then continued to conceal his losses by manipulating volatilities in the DEM swaptions book so as to overvalue positions on that book. Papouis continued to manipulate volatilities on the DEM options and swaptions books so as to overvalue positions until he left NWM on 16 December, 1996. However, he did not attempt to hide any trades. In February 1997 the DEM options and swaptions books were written down by 55.6 million following the discovery of the mismarking.

Central to the failure in the organisation of NWMs risk management lay the fact that Papouis was able to pass the key option pricing parameter implied volatility to the back office for the daily mark-to-market valuations. Best practice risk management calls for an independent verification of these parameters in order to avoid precisely this opportunity for mismarking:

- Models: models used to price and value options and swaptions should be reconciled if the front and back office are using different models;

- Data: implied volatility is a key input into option and swaption pricing models. Having traders pass daily implied volatilities to the back office without independent verification invites attempts to value falsely or conceal losses; and

- Outputs: outputs from models (eg, prices) should be calibrated against external data (eg, market prices). Pricing that is consistently off-market (especially for listed instruments) is a warning flag that something in the risk management process is amiss.

The SFA investigation concluded that Papouiss supervisor, Neil Dodgson, sometimes also marked the value of exchange-traded options in the GBP book at higher levels than those prevailing in the market. The final estimate of losses in the GBP options and swaptions portfolio was 24.6 million.

The losses were announced on February 28, 1997. To its credit, NWM demonstrated remarkable transparency in its initial handling of the situation, immediately suspending four managers and launching an internal investigation. Losses were initially estimated at 50 million. By June, the internal investigation had pinpointed Papouis as the trader that had incurred and attempted to conceal losses, and the loss estimate was rising.

As details of the off-market pricing and concealment of losses over an extended period became more widely known, market participants and investors began to question NWMs failure to ensure proper internal control and risk management. Many observers noted that the risk management breakdown had occurred in the same period that banks were reassessing risk and control practices in the aftermath of the 1995 collapse of Barings Bank. By June, six managers had resigned from NWM, including Dodgson and several senior and risk managers. The carnage continued up the line, and the head of investment banking, Martin Owen, also felt obliged to resign.

The SFA launched an investigation into the losses in summer 1997, the results of which were released on May 18, 2000. Somewhat surprisingly, the SFA found that management of NWM had been notified on several occasions by both internal and external auditors about control issues at NWM between January 1994 and February 1997.

Issues that particularly worried the SFA included:

- The finding that back-office valuation/reconciliation procedures had not been performed properly between March 1995 and February 1996;

- That independent valuation of trading positions was inadequate;

- Computer systems were inadequate, and finance and operations areas in the bank were not suitably resourced due to a shortage of skilled staff; and

- The interface between functional areas in the bank was not clear, the control environment was inadequate, and there was significant and widespread non-compliance with internal minimum control standards right across NWM.

The SFA imposed a financial penalty of 420,000, in total, on NWM and National Westminster Bank. Papouis was found to have violated principles of integrity and fair dealing, while Dodgson was reprimanded for not acting with due skill, care and diligence.

However, the investigations did not suggest that there had been widespread collusion at the bank, or that the mismarking had been conducted in the pursuit of personal gain. Both Papouis and Dodgson were fined by the SFA, to the tune of 50,000 and 5,000 respectively, and Papouis was expelled from the register of traders. The final estimate of direct losses in the banks portfolios was 90.5 million.

March 1995 to December 1996 Period in which interest rate options and swaptions are alleged to have been mispriced and losses concealed in NatWest Markets, the corporate and investment banking arm of National Westminster Bank.

December 16, 1996 Kyriacos Papouis, interest rate options trader, leaves Natwest Markets for Bear Stearns.

February 28, 1997 Concealed losses discovered in interest rate options and swaptions trading books of NatWest Markets, estimated at 50 million. Neil Dodgson, Papouiss supervisor, suspended for failure to supervise.

March 13, 1997 Four additional managers in NatWest Markets suspended as it emerges that management had not identified the losses for more than a year.

June 16, 1997 Martin Owen, head of investment banking, resigns; National Westminster Bank takes 50 million charge.

July 23, 1997 Investigation by the Serious Fraud Office avoided as no criminal activity is deemed to have taken place, though an investigation by the Securities and Futures Authority continues. Amount lost estimated at 77 million.

Securities and Futures Authority, SFA Disciplines NatWest and Two Individuals, press release, May 18, 2000. Note that the PDF document associated with the original press statement contains details not included in html press release.

David Shirreff, Lessons from NatWest, Euromoney, May 1997

The Financial Times published a series of stories on the unfolding debacle:
NatWest trader suspended over options loss, February 28, 1997
The maths dont add up for bankers: The NatWest case points up the dangers of complex options trades, February 28, 1997
Deep-rooted reasons for NatWest loss: Banks say nature of options trade can invite bad practice, March 3, 1997
NatWest move on option losses sends shares down, March 3, 1997
When the smile is wiped off: NatWests 50m losses on options trading highlight the risks in pricing these obscure financial instruments, March 7, 1997
NatWests chiefs failed to spot deals mispricing, March 7, 1997
NatWest Markets holed above water line: Debacle of options mispricing has called into question the investment banks quality of management, March 13, 1997
NatWest suspends four managers; Staff bonuses cut as derivatives losses rise to 90m, March 13, 1997
Fraud office considers NatWest Markets probe, March 14, 1997
NatWest issues profits warning: Head of investment banking arm quits after 77m loss, June 16, 1997
NatWest managers cleared: Inquiry finds no collusion in options loss, June 22, 1997
Six depart at NatWest after 77m loss, June 26, 1997
NatWest Markets avoids fraud inquiry, July 23, 1997
NatWest and traders fined 480,00 for malpractice, May 18, 2000
NatWest fined by SFA after loss of controls, May 19, 2000

This ERisk case study was contributed by Eric Wolfe, manager, market risk in the pro-trading group at National Bank Financial. The views expressed in this article are his alone and do not necessarily represent the views of National Bank Financial.