The loss hidden inside the model

Graduate · enrolled learners

This lesson opens with Daiwa Bank and Toshihide Iguchi, 1995.

What happened

Toshihide Iguchi was a bond trader at Daiwa Bank's New York branch who also controlled the back-office function that recorded and held the securities he traded, and over roughly eleven years he hid about 1.1 billion dollars of trading losses by exploiting that dual role. When his trades lost money, prosecutors said, he sold bonds from Daiwa's own accounts and its customers' accounts to cover the losses, then forged documents so the sales looked authorized and the books still showed the securities on hand, about 30,000 unauthorized trades by the bank's count, so the recorded picture of the bank's positions stayed healthy while the real positions bled away. The bank's oversight read those records and saw nothing wrong, because the records were exactly what the person hiding the loss wanted them to say. The losses accumulated for over a decade until Iguchi confessed in a letter to the bank's president dated July 13, 1995. Daiwa's senior management then kept the losses from US regulators for about two months, and on November 2, 1995 US federal and state regulators ordered Daiwa to end all its US banking operations within 90 days. The risk system was not defeated by clever trading; it was fed false inputs by the one person who both took the risk and kept the records, so its picture of reality, the model it reasoned on, was a fabrication.

The decision point

A risk system does not observe reality directly; it reads a recorded picture of the firm's positions, the model of what is held and what it is worth, and reasons on that, so if the records feeding it are false, the risk system is confidently wrong, and a loss can hide inside that recorded picture indefinitely. Daiwa is the case: a trader who also controlled the back office hid about 1.1 billion dollars of losses for eleven years by selling custodied securities and forging the records so the books still showed them held, so the risk oversight saw a healthy position that did not exist. The crucial structural point is who produces the records: when the person taking the risk also controls the records the risk system reads, the risk system is fed its inputs by the one party with a motive to lie, so it is blind to exactly what that party hides. This is why the loss can hide inside the model, because the model is only as truthful as its inputs, and the inputs came from the trader. The defense is independence of the record from the trader: the confirmations, custody records, and position data a risk system relies on must come from a source the trader does not control, so that a hidden loss cannot be papered over at the source. So the discipline is to ensure that the records feeding any risk measure are produced independently of the person taking the risk, to treat a risk number built on trader-controlled data as unverified, and to recognize that a risk system is only as honest as the records it reads, because Daiwa shows that a loss placed inside a captured record can grow for a decade while every risk report says all is well.

Recorded loss

$1,100,000,000

Orientation and Year One are open: anyone can read them without an account. From Year Two onward the lessons are for enrolled learners, because progress through the later years only means anything if it is tracked against a record.

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