The big banks have ramped up their trading businesses in recent years and, to the delight of shareholders, the strategy has boosted earnings and share prices. But, as Bank of Montreal recently discovered, trading also brings big risks.

BMO surprised the market on April 27 by announcing it would probably suffer trading losses of $350 million-$450 million. On May 17, it revised that number to $680 million in losses and incentive compensation adjustments. Of that, $509 million (46¢ a share) will be recorded in BMO’s soon to be restated first-quarter results; the remaining $171 million (18¢) loss was included in BMO’s second-quarter report.

Large and surprising trading losses rekindle memories of earlier scandals: Nick Leeson, the rogue trader who single-handedly brought down Barings Bank; the gang of geniuses behind Long-Term Capital Management LP that saw their highly leveraged bets go sour; and the frat-boy antics of Enron Corp.’s traders, which were recorded on tape for posterity. The reputation of the trading business has clearly had rough times.

At BMO, the two top traders in its commodity business have left the bank. BMO has also ceased doing business with Valhalla, N.Y.-based derivatives brokerage house Optionable Inc. , pending the outcome of an ongoing review of BMO’s trading business.

Optionable issued a statement expressing regret about BMO’s losses, but stressed it was not responsible for directing the bank’s trading strategy. The firm — a brokerage and execution house — doesn’t provide advice: “We believe strongly that our brokerage and execution services are and have been rendered appropriately, professionally and correctly.”

At this point, it’s not entirely clear what went wrong in BMO’s trading operation. BMO is investigating potential trading irregularities. And early on, BMO’s new president and CEO, Bill Downe, attributed the trouble to “decisions that didn’t adequately recognize the vulnerability of the portfolio and changes in market volatility.”

But, regardless of the cause, the episode is casting light on a poorly understood portion of the banks’ businesses. Analysts expect the area will see increased attention as the banks enter the reporting season for their fiscal second quarters ended April 30.

Looking ahead to the banks’ earnings announcements, a UBS Securities Canada Inc. report predicts trading results and businesses “are likely to be in sharp investor focus” following BMO’s misadventure: “While we believe the event is largely BMO-specific, the industry has clearly grown and benefited from trading activities, and disclosure is very limited.”

The big banks have been enjoying an increase in trading revenue in the past few years. A report by Desjardins Securities Inc.analyst Michael Goldberg states the banks’ combined trading revenue exceeded $6.1 billion in fiscal 2006, up from $5.4 billion the prior year. The Desjardins report forecasts the total will rise to a combined $6.6 billion this year — including BMO’s anticipated losses — and $7 billion next year.

BMO isn’t the biggest trader among the banks. Its trading revenue totalled $665 million in 2006, according to the Desjardins report, making it the smallest of the Big Five. Royal Bank of Canada is by far the biggest trader, generating more than $2.1 billion in annual revenue from the business activity.

Although the banks’ combined trading revenue has been increasing in the past few years, trading remains a relatively small part of overall revenue for the banks, ranging between 3% and 6%, the Desjardins report estimates.

But trading contributes much more significantly to the bottom line. In a report, BMO Capital Markets Inc. analyst Ian de Verteuil estimates trading contributes 10%-20% of total bank earnings — about $2 billion-$2.5 billion in annual, after-tax earnings, with an annual return on equity of more than 25%.

This relatively high ROE, coupled with the fact that trading results don’t seem to be correlated with the credit cycle, means trading has helped sustain bank earnings when the core lending business has weakened, de Verteuil notes. Such profits favour the banks continuing to expand their trading operations.

There can be little question the banks have benefited from their trading activities, but what’s disconcerting is how little insight most analysts and investors have into this part of bank business, and how quickly large losses can mount.

The Desjardins report indicates the banks’ trading operations are essentially “black boxes,” making it difficult to forecast the revenue they may produce: “What is particularly troubling, given the magnitude of trading revenue for the banks, is we do not feel like we have any useful barometers with which to gauge trading revenue (such as volume and margin).”

@page_break@The Desjardins report notes that a satisfactory explanation for how banks estimate trading revenue has not been found: “Sometimes we are told trading revenue fluctuates with volatility, or that value at risk (VaR) is a useful metric, but we have never been able to see any correlation between VaR and trading revenue.”

The weakness of disclosure surrounding trading activities means the segment can produce surprises. Some are welcome, such as in Royal Bank’s first quarter this year, when it beat some analysts’ estimates of its trading revenue by almost $100 million.

Nevertheless, analysts tend not to like surprises, so on the conference call that followed BMO’s trading-loss announcement, analysts pushed BMO executives for more insight into the trading business. BMO’s chief risk officer, Bob McGlashan, suggested on the call that VaR is an acceptable indicator of the bank’s trading book for most sectors, but that the tight, illiquid natural gas markets that caused its losses are an exception. That said, CEO Downe says the bank will look at providing a different form of disclosure for the natural gas portion of its trading book in the future.

It remains to be seen if, and how, the banks expand disclosure of their trading operations. In the meantime, analysts seeking some insight into the causes of the BMO loss, and the prospect of losses at other banks, are taking comfort in the fact that the BMO loss appears to be an isolated incident. The problem seems fairly specific to the commodity trading business (a rapid decline in volatility); BMO has, by far, the biggest exposure to commodity derivatives among the big banks.

The bank has seen its derivatives exposure expand significantly in the past year. As Downe explained in the conference call with analysts, the bank increased its trading revenue in response to increased demand for commodity derivatives following hurricane Katrina, which increased natural gas prices and market volatility. The result is that while all the banks may have been ramping up their use of derivatives, it was BMO that focused on commodity derivatives in general and in natural gas in particular.

A report by Blackmont Capital Inc. states the notional value of outstanding derivatives contracts at BMO grew by 47% in 2006. A Genuity Capital Markets report notes that BMO’s VaR in the commodity business was $16.8 million in the first quarter of 2007, up from $8.4 million in the same quarter a year earlier. By comparison, Royal Bank’s commodity VaR was just $1 million in the first quarter, and the bank with the second-biggest exposure, TD Bank Financial Group, had a VaR of just $3.8 million. Given that the conditions that apparently caused the BMO loss are specific to the commodity markets, it seems that there shouldn’t be much to worry about for the other banks.

That said, the situation at BMO highlights other issues that may not portend imminent losses, but could be a concern for investors.Risk management at large institutions may not be good enough to deal with unanticipated market developments, for one. Also, the size of BMO’s loss compared with its reported VaR questions the usefulness of that statistic as a measure of trading risk.

VaR has its critics. Some argue that although it may do a decent job of quantifying mundane trading risks, it doesn’t prepare for extreme events. This time, it was commodities; next time, it could be moves in the equities, interest rate or foreign exchange markets that are outside the parameters for which traders had planned, sparking losses in different areas.

For risk-management practices, avoiding large losses and negative impacts on earnings should be incentive enough for bank management to be careful with their trading exposures. As the Desjardins report points out, however, there’s a contrary incentive at work — the risk of moral hazard among successful traders: “Professionals who have produced strong revenue lines over time have been able to accumulate significant personal wealth, which can desensitize them to the risk of loss. If everything goes right, the bank wins and they win; but if something goes wrong, they ‘retire’ and the bank eats most of the loss.

“Banks manage this risk by setting limits and controlling exposure relative to those limits,” the report adds. “But, to do so, they have to understand the risk being taken.”

Before the prospect of large trading losses was announced, BMO was seen as one of the more cautious banks. The lesson it has now learned will not be lost on other bankers, analysts and, presumably, investors. “While we believe the issues in BMO’s trading book are largely company-specific, it is a stark reminder of the risk inherent in those business lines and the unpredictability of their ability to deliver income,” notes the UBS report.

This sentiment is echoed in the Blackmont report, which says BMO’s losses “should act as a wake-up call for investors who may not have appreciated how the risk profile of domestic banks has shifted in the past 20 years since embracing global capital markets.” IE