AIB Group, comprising Allied Irish Bank p.l.c. and its subsidiaries, conducts a broad retail and commercial banking business in Ireland, mainly offering mortgages, loans, insurance, savings and current accounts for customers, pensions and investments and, includes significant corporate lending and capital markets activities from its head office at Bankcentre and from Dublin's International Financial Services Centre.
Four decades since its formation, AIB is a dynamic and successful organisation. In 1966, AIB's aggregate assets were €323.8 million as at 31 December 2005, AIB Group had assets of €133 billion.
AIB's subsidiary, Allfirst, experienced a planned and scrupulously fraud implemented by John Rusnak, extended over a long period of time which mainly involved falsification of key bank records and documents.
Chain of Events
AIB's subsidiary, Allfirst was looking to expand into proprietary foreign exchange trading as it wanted to create a niche player in the foreign exchange market (Forex). In 1993, John Rusnak was hired as a foreign exchange trader, to bring profits to Allfirst bank. Prior to Rusnak's arrival, foreign exchange trading at the bank was limited to assisting bank customers in hedging against currency risk and performed this service for companies that were dealing with overseas trades.
Rusnak's job was to make arbitrage profits by taking advantage of discrepancies in the price of currencies in the cash, futures, foreign exchange options and the spot and forward Forex. The latters should have been a strategy that should in theory have allowed him to make profits consistently by buying options when they were cheap and selling them when they were expensive.
Rusnak's core trading belief was that the yen was going to rise against the dollar. His strategy throughout all his trading was to place bets in this direction. During the time period Rusnak was trading from 1990 to 1995, the yen appreciated. From mid-1995 to 1997, the yen was depreciating against the dollar. In April 1997, exchange rates were around 125 yen to the dollar. The Asian market crisis followed soon after causing further problems for the yen. From 1993 to 1997 at Allfirst, Rusnak appeared to be doing well. One may contemplate that from 1990 to 1995, he was able to do well with his market view. However as the yen depreciated, Rusnak eventually began to have great problems with his one-sided trading.
During the period 1997 to 2001, Rusnak incurred heavy losses in foreign exchange transactions. Particularly, at the end of 1997 it appears that he made serious losses by using these currency forwards to take a position on the movement of the Japanese yen. However, instead of taking responsibility and reporting his losses immediately he decided and was able to hide them successfully by creating fictitious option trades that offset those that were genuine and which gave the impression that his real positions were hedged. He manipulated bank records, documents and reported false profits. Due to the senior management's carelessness, and lack of knowledge and experience in foreign exchange trading, Allfirst ended up in a financial mess.
The interim [AIB Group, 2002] into the fraud(s) perpetuated by John Rusnak against the AIB subsidiary Allfirst Bank reports that: "Mr. Rusnak circumvented the controls that were intended to prevent any such fraud by manipulating the weak control environment in Allfirst's treasury; notably, he found ways of circumventing changes in control procedures throughout the period of his fraud."
Trading Strategies employed by Rusnak
The foreign currency market is the market that John Rusnak gambled and lost in. He used spot transactions, forward transactions and options to amass losses. He then used different techniques to hide his losses.
False Options
The first technique Rusnak used to hide his losses was to enter false options in Allfirst's banking system. The purpose of these bogus options was two-fold; they appeared to hedge his directional trades and they also gave him a way to hide the losses with a false asset. At the end of his trading day he would enter two false trades in the bank system, two options that would offset each other. The put option that was 'sold' expired on the same day written and its liability went off the books immediately. On the other hand, the call option that was 'purchased' stood on the books as an asset of the bank and the value of the option covered the losses. Two options were necessary so the received premium and the paid premium cancelled out so that the back office did not have to make any net payment.
Falsified documents
Fake options only solved the problem of covering the losses, but created another problem. The Treasury back office was responsible for confirming every trade. The foreign exchange operation at Allfirst was operating on a shoestring compared to what a large bank would have in place. Typically a true foreign exchange operation had research departments, dealing rooms, computer programs that automatically confirmed trades and a more sophisticated set-up. Allfirst was using telephone and fax to execute and confirm trades. Rusnak knew that the Treasury back office was going to need to confirm his trades, so he used his PC to create false trade confirmation documentation. In fact, his PC was discovered to have a directory called "fake docs", which contained logos and stationary from various banks in Tokyo and Singapore. In this way he was able to convince the treasury back office to accept these documents from him, rather than confirming the trades themselves as required. Subsequently, he was able to convince the back office not to confirm the trades at all by arguing that since the trades netted to zero, they did not need confirmation.
Prime Brokerage Accounts
These types of accounts are typically used by high profile traders and are very often used by hedge funds. Rusnak needed to increase the size of his trades so he could catch up on his losses, hence these accounts provided him with net settlements. Daily spot transactions were rolled into one forward transaction to be settled at a future date with the prime broker, meaning that the Treasury back office could not track his daily trades as effectively.
The prime brokerage accounts allowed Rusnak to use a type of foreign exchange contract called a historical rate rollover. Entries were reversed before month end reconciliation to hide losses. However for a trader, these types of contracts allow losses to be rolled forward. If the trader's contract is due to be settled, and settlement would not be in his favor, he can delay settlement and keep the original rate of the contract.
Value at Risk calculations
John Rusnak avoided detection by manipulating the bank's Value at Risk (VaR) calculations. VaR is calculated using the Monte Carlo simulation technique. One thousand hypothetical exchange rate fluctuations are generated and are applied to the trader's portfolio. The tenth worst outcome produced is the bank's VaR. The VaR is the largest amount of money a bank can afford to lose if there are adverse trading conditions. Rusnak's VaR was $1.5 million. However at the end of 1999, he had already lost $90 million. He had clearly found a way around this check.
Sale of options
In order to reduce his losses, instead of using Allfirst's cash, Rusnak got loans from other banks and used that money for his investments. By the end of 2000, he had lost $300 million. He was getting pressure from his superiors to reduce his use of the company's balance sheet, and since he needed cash to earn back the money he had lost he came up with the idea of selling deep-in-the-money options at high premiums to finance his trading. The options he sold had deep-in-the money strike prices. The latter were so deep it was extremely likely that the options would be exercised. They were European options that expired in a year and a day and were essentially loans from the counterparties to Allfirst, to Rusnak. He received millions of dollars in premiums for the options. He would "pay back" the money when the option was exercised in a year.
Losses Revealed
John Rusnak avoided an amazing number of situations where he could have been caught. He avoided detection over a period of five years. A particular situation occurred during the one audit conducted at Allfirst during the five year time period of the fraud. Rusnak was asked to confirm an Asian trade that was bogus. He successfully set up a fax account at Mailboxes etc. in Manhattan under the name David Russell. He gave the fax id code of that account to the auditors. The auditors faxed a confirmation request to that fax id. Rusnak then called the Mailbox etc. store, posed as David Russell and had them fax a return confirmation.
At one point, the bank gave Rusnak Travel Bloomberg software so that he could trade from home and while on vacation. This was a direct violation of U.S. law. U. S. law requires that traders take 10 consecutive days off from trading every year. This is specifically so someone else takes over their duties and fraud can be discovered.
Finally in December of 2001, John Rusnak's luck began to run out. A treasury back office supervisor happened to look over the shoulder of one of their employees and saw that there were two trade documents from Asian trades that Rusnak executed that did not have attached confirmations as required. The supervisor discussed with the employee that all trades had to have confirmations.
Conclusion
The foreign currency market is the market that John Rusnak gambled and lost in. He used spot transactions, forward transactions and options to amass losses of $691 million. Rusnak focused on spot and forward contracts in his trading. Rusnak lost the money and covered the loss in hopes he could win it back perpetrated this fraud alone so he had no direct accomplices. However, there were indirect accomplices, such as AIB itself and the people that were not responsible and supervised as appropriate. Estimates of the total losses to Allfirst's parent company from the debacle now stand at around $691 million. While the bank's solvency was not threatened in the immediate consequences of the losses' discovery, the bank was able to absorb the losses by a one-time charge on earnings. The loss was large enough to wipe out 60% of AIB's 2001 earnings and significantly deplete its capital.
