Financial risk (mis)management has entered Australia’s mainstream media courtesy of a rogue trading scandal at the National Australia Bank (NAB).The bank has garnered plenty of attention after its discovery of a $180 million hole in its accounts — a result of unauthorised foreign exchange options transactions conducted by four National staff, three based in the bank’s Melbourne headquarters, one in London.

Since the initial announcement to the ASX, market rumours have suggested the loss could be as high as $600 million, or around 10 per cent of the bank’s pre-tax earnings. NAB’s chief executive Frank Cicutto, the main media and shareholder target, said it was unlikely the losses would be that high.

Most critics were left asking “how could this happen?” After all, risk controls are key for large international banks, especially in dealing rooms where millions of dollars change hands at the touch of a button. And these risks have largely been addressed as a result of globalisation and increasing awareness of corporate governance issues.

The big question being asked in the days following the discovery of the losses was how did the dealers manage to circumnavigate the bank’s risk management systems. The bank’s answer was that because the transactions were not authorised and were not correctly recorded, the risk management controls did not pick up the suspect deals.

One theory put forward in the media suggests the dealers managed to bypass the bank’s risk management systems by taking advantage of daily risk control checks. Ahead of these checks, the theory suggests, which took place at pre-appointed times during each trading day, the dealers transferred the rogue trades from Australia to London. Ahead of the London checks, the reverse would happen and the trades would make their way back south of the equator, keeping the risk management system in the dark.

Reports suggest that the traders concerned racked up huge losses last October, and subsequently attempted to hide the losses by betting on Australian and NZ dollars. The bank said it was confident that systems would have picked up the problems eventually and the likelihood of collusion between the four dealers potentially means their individual limits would not have been breached. In the final analysis, it was a whistleblower at the bank’s Melbourne trading centre who eventually alerted management.

The accused traders meanwhile hit back, maintaining the bank was well aware of the breach of internal limits.

In the wake of the scandal, NAB’s competitors rushed to make claims that their risk management controls had their full confidence. But the fact is that this type of problem has occurred many times before and is likely to occur again. The most notorious example of rogue trading occurred in 1995 when British dealer Nick Leeson, also facing huge losses, gambled to avoid them and ended up losing around $1 billion through unauthorised derivatives trading. The Bank of England subsequently closed down Barings Bank, one of the UK’s oldest investment banks, and Leeson found himself in prison in Singapore.

More recently John Rusnak, a foreign exchange trader at AllFirst, a subsidiary of Allied Irish Banks in the US, managed to lose around $1.5 billion and admitted trying to hide the losses. He is currently serving a seven-year sentence in the US, becoming one of the first post-Enron ‘white-collar’ criminals to end up behind bars.

It is possible the NAB protagonists could find themselves on the end of criminal proceedings as the Federal Police is reported to be investigating the incident. The Australia Prudential Regulation Authority is also looking into the details. The bank has not yet accused the four dealers of fraud, but with investigations by KPMG, the bank’s auditors, and forensic accountants from PricewaterhouseCoopers, there may be more to come on that issue.

Several questions remain for NAB: How can the bank balance the dual needs to maximise profit and to avoid costly mistakes? Is there a risk management system that could have prevented this? After all, it appears the NAB traders were able to manipulate the system. The final question, and perhaps the most pertinent, is whether the bank misled investors with its initial announcement to the ASX. If the figure does mount up, shareholders will be less than pleased about NAB’s initial assumption that the losses were unlikely to exceed $180 million pre-tax.

And the irony of the story? Foreign exchange options are used by many corporate firms with overseas operations to manage currency exposure risks.