An ERisk.
com Case Study
NatWest Markets
n February 28, 1997,
O 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 discov-
ered in its interest rate options and
swaptions trading books. The loss
figure escalated to £90.5 million
after further investigations.
NWM’s troubles started with a sys-
tematic 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 bank’s books in a concerted
attempt to cover up the losses. His
supervisor, Neil Dodgson, who
traded Sterling (GBP) interest rate
options and swaptions, also mis-
marked 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 UK’s Financial Services
Authority, or FSA.)
The fallout was swift and substan-
tial. 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
Westminster’s investment banking
group, also resigned. Rightly or
wrongly, confidence was shaken so
badly that in July 1997, the Bank of
Lessons learned
G Roles and responsibilities must be clearly delineated between the
front, middle and back offices: failures in risk management are primarily
failures in process.
G 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.
G 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).
G Pricing that is consistently ‘off-market’ is a warning flag that
something in the risk management process is amiss.
G A communications strategy for managing public perceptions is vital.
NWM’s debacle might have been even worse without the bank’s
prompt disclosure of the losses and the active and relatively open way
in which it pursued its enquiries.
England had to instruct NatWest to ment models pose to modern
resist calls for the resignation of its banks. But some of its lessons are
most senior executives in an effort simpler. The SFA said that NWM’s risk
to draw a line under the affair. management process failed to
The bank’s internal controls and identify a clear case of mispricing
risk management were questioned for almost a year, and then failed
and severely criticised in May 2000, to spot the concealment of losing
after a lengthy SFA investigation. positions, because of “significant
The regulator imposed a penalty and widespread non-compliance
of £420,000 on NWM, and fined and with internal minimum control stan-
reprimanded Papouis and Dodgson dards”.
for breaches of SFA principles. But
the real damage was to percep- The story: why option
tions of the quality of National pricing is not a science
Westminster’s management, risk NatWest, like many other interna-
control and overall strategy. Some tionally active banks, had moved
analysts feel that the losses in the aggressively into investment bank-
capital markets – small in relation to ing in the 1990s. This meant building
the size of the bank – undermined a presence in the rapidly growing
confidence in National Westminster derivatives markets. Papouis and
so badly that that they helped set Dodgson worked in the rate risk
the scene for the Royal Bank of management area of NWM, where
Scotland’s successful takeover bid interest rate options and swaptions
in February 2000. were traded on a number of under-
The debacle has become a clas- lying currencies.
sic example of the risk that sophisti- Market observers suggested at
cated pricing and risk manage- the time that the root of NWM’s
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problems lay in the aggressive pric-
ing 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 con-
cluded that the debacle as whole
was not inspired by the pursuit of
personal gain.)
The difference between compet-
itive and risky pricing by traders is
not always obvious to manage-
ment in the options market. This is
because one of the key parame-
ters 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 partici-
pants 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 esti-
mated.
Yet the implied volatility of an
underlying asset is also the key rela-
tive 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 option’s valu-
ation can be miscalculated or
manipulated.
And there’s an extra complica-
tion: 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. Let’s assume that all of the
options are on DEM interest rates,
with the same expiry date. The fig-
To the extent there is no
‘
“right” or transparent price
for an option, there is a risk
that an option’s valuation can
be miscalculated or
manipulated’
ure shows the implied volatilities of
options with strike prices ranging
from 3 to 7 per cent. Clearly, the
market’s view is that implied volatil-
ities 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
ERisk.com
1. The volatility smile
implied
volatility
(%)
out-of-the at-the-money out-of-the-money
-money
implied volatility
smile
average
implied
volatility
strike price (%)
3 4 5 6 7
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.
It’s 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 Papouis’s 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
trader’s actions. Furthermore, at this
point, most of the losses were
related to exchange-traded DEM
options. These losses should have
been relatively easy for NWM’s
back office to spot, given the dis-
crepancy between any values in
the bank’s systems and readily
available market price data sup-
plied by the exchange.
However, when in February 1996
a member of NWM’s back-office
staff belatedly pointed out the
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02

Timeline of events
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, Papouis’s supervisor,
suspended for failure to supervise.
March 13, 1997 Four additional
managers in NatWest Markets
suspended as it emerges that
discrepancies between the
exchange market prices and the
prices recorded in the bank’s back-
office systems, Papouis was simply
told “something had to be done
about them”.
According to the SFA investiga-
tion, Papouis’ solution was to
attempt to conceal the losses in the
DEM interest rate options by under-
taking a series of off-market trans-
actions between his DEM options
portfolio and his swaptions portfo-
lios. These made good the DEM
options portfolio, where it was easy
to see the losses, to the disadvan-
tage of the DEM swaptions portfolio
where losses were easier to con-
ceal. The SFA report explained that
Papouis then continued to conceal
his losses by “manipulating volatili-
ties in the DEM swaptions book so
as to overvalue positions on 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.
May 19, 2000 National
Westminster Bank and NatWest
Markets fined £420,000 by SFA;
final estimate of losses put at
£90.5 million. Disciplinary action
taken against Papouis and
Dodgson.
book. Papouis continued to manip-
ulate volatilities on the DEM options
and swaptions books so as to over-
value 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 NWM’s 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 verifica-
tion of these parameters in order to
avoid precisely this opportunity for
mismarking:
G Models: models used to price
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and value options and swaptions
should be reconciled if the front
and back office are using different
models;
G Data: implied volatility is a key
input into option and swaption pric-
ing models. Having traders pass
daily implied volatilities to the back
office without independent verifi-
cation invites attempts to value
falsely or conceal losses; and
G 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 Papouis’s 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 Aftermath
The losses were announced on
February 28, 1997. To its credit,
NWM demonstrated remarkable
transparency in its initial handling of
the situation, immediately suspend-
ing four managers and launching
an internal investigation. Losses
were initially estimated at £50 mil-
lion. By June, the internal investiga-
tion 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 pric-
ing and concealment of losses over
an extended period became more
widely known, market participants
and investors began to question
03

NWM’s failure to ensure proper
internal control and risk manage-
ment. 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 contin-
ued up the line, and the head of
investment banking, Martin Owen,
also felt obliged to resign.
The SFA launched an investiga-
tion into the losses in summer 1997,
the results of which were released
on May 18, 2000. Somewhat surpris-
ingly, the SFA found that manage-
ment 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:
G The finding that back-office valu-
ation/reconciliation procedures
had not been performed properly
between March 1995 and February
1996;
G That independent valuation of
trading positions was inadequate;
G Computer systems were inade-
quate, and finance and operations
areas in the bank were not suitably
resourced due to a shortage of
skilled staff; and
G The interface between functional
areas in the bank was not clear, the
control environment was inade-
quate, and there was “significant
and widespread non-compliance
with internal minimum control stan-
dards” 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 per-
sonal 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 bank’s portfolios was
£90.5 million.
Arguably, however, the real cost
lay in the effect the debacle had
on National Westminster’s reputa-
tion. The quality of management
and internal controls were harshly
criticised, and the aggressive push
into investment banking ques-
tioned. The bank’s movement into
seemingly complicated derivative
products that it did not fully under-
stand seemed to indicate poor
management. By the end of 1997,
parts of NWM had been sold to
Bankers Trust. Some analysts believe
that the erosion of investors’ trust in
National Westminster led eventually
to the sale of National Westminster
Bank, after a brief bidding war, to
Royal Bank of Scotland in early
2000. I
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.
ERisk.com
Resources and References
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 the 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 don't 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: NatWest's £50m losses
on options trading highlight the risks in pricing these
obscure financial instruments”, March 7, 1997
“NatWest's 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 bank's 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 £480,000 for
malpractice”, May 18, 2000
“NatWest fined by SFA after loss of controls”, May 19,
2000
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