Accounting for the City rogues

Investors in unit trusts and other savers have had some lucky escapes recently. It is a fluke that they have avoided losing money as a result of the activities of rogue traders in the City. On Friday evening, National Westminster Bank announced that a member of its staff had lost pounds 50m. Fortunately, the bank is covering the deficit out of its own pocket and no client will suffer.

When Morgan Grenfell's highly regarded executive Peter Young made a series of illicit and disastrous investments for funds in which the general public has an interest, the bank was no longer independent. On its own, it would have been unable to rectify the situation. But some years earlier it had been taken over by the immensely strong Deutsche bank. The Germans are putting up the pounds 300m required to make sure that none of Morgan Grenfell's clients suffer any loss. In the case of Barings, whose Singapore operative Nick Leeson ran up pounds 830m of losses, he was misusing Barings's own money rather than anybody else's. The City's oldest merchant bank vanished, repayment of its bond was put in doubt and the Baring family became a laughing stock, but that was that.

It is purely fortuitous that no member of the public has yet been affected. Go through the advertisements in the weekend press offering unit trusts and investments trusts and other schemes for investing in shares. Then ask the question: how many of the companies making these enticing claims with their 'unbeatable costs", their exhortations to act now, their free phone numbers, actually have pounds 50m, or pounds 300m, or pounds 830m to make good any losses incurred by their own employees who deal outside their limits and then cover up their mistakes? Very few.

The accident is waiting to happen because the City has created a system for rewarding key staff which has a perverse effect. The payment of large bonuses for the above-average performance encourages undue risk-taking, particularly as there is never any financial penalty for poor achievement. As the Bank of England points out in a study published yesterday, "the highest bonuses usually go to 'stars' who may feel compelled to justify their status by taking greater risks in the hope of making higher and higher profits". Winner-takes-all payments systems are now a feature of the financial markets, as they are of the entertainment industries and of professional sports.

This means that the standard health, or rather wealth warning in the advertising of financial products is inadequate. In the small print you are told that past performance is not necessarily a guide to future performance, and that both capital and income values may go down as well as up, and that you may not get back the amount invested. That is the investment risk. What the NatWest, Morgan Grenfell and Barings cases show is that there is another aspect to be considered: the prudential risk - in other words, the question of honesty.

There are many things that can be done to enhance the level of protection against this new danger - which isn't going to go away because the Bank of England writes a paper disapproving of City bonus schemes. Savers must begin to ask the companies managing their unit trusts or investment trusts and similar products: do you have the resources to meet losses of upwards of pounds 100m caused by dishonest trading?

Here, the recent action by the admirable Mercury Asset Management, the largest independent fund manager in the UK, is telling. It has arranged a standby loan of some pounds 250m which can be drawn down in an emergency. This would be in addition to the pounds 300m in surplus cash that the company has already accumulated. No other management group has yet followed Mercury's example.

Savers, therefore, must spread their risks in the time-honoured fashion. Just as it would be foolish to invest all your savings in a single share, so it is now imprudent to entrust your entire nest egg to the unit trusts or investment trusts of a single investment management group unless it is big enough to handle any conceivable disaster arising from dishonest trading. The extra charges should be seen as a type of insurance premium.

There is likewise a classic response that the City's regulatory authorities, among them the Personal Investment Authority and the Investment Management Regulatory Organisation (IMRO), can and should make. Without further ado, they must insist on disclosure to highlight the new risk. Unit trust and investment trust managers advertising to the public should be required to state who their ultimate parent companies are, what their paid-up capital amounts to, and, in cases where the ultimate owners are banks, what their credit rating is. Investors need to be able to assess strength as well as expertise.

And of course the obligatory warning must be rewritten to reflect reality. Not only can share prices fall as well as rise, but unauthorised activities by the investment manager's staff could lead to large losses. This needs to be spelt out clearly. Rogue trading can damage your health.