Investors' Regret: Société Générale v Jérôme Kerviel

On 4th July 2008, The Banking Commission of France (BCF) fined Société Générale €403 million euros for the bank's lack of internal controls in a €4.9 billion trading loss in January 2008.  SocGen blames 'rogue trader' Jérôme Kerviel for the loss after it discovered his trading positions on 18th January.  SocGen's chairman Daniel Bouton also blamed Kerviel for the stockmarket's 6% fall on 21^st January 2008.

Kerviel counter-blames SocGen for its loss, fired his lawyers, and adopted an aggressive stance with a new legal team during a court hearing in France on 23rd July.  SocGen had already suffered fallout from the revelations about Kerviel's losses: Bouton made changes to senior management, and the French bank had to raise €5.5 billion euros to recapitalise, and prevent SocGen from becoming an M&A takeover target.

SocGen's 'rogue trader' claim against Kerviel recalls the fate of trader Nick Leeson whose speculation on derivatives and options markets led to the collapse of Baring's Bank in 1995.  Leeson attempted to trade himself out of bad decisions through his knowledge of exotic options, his control of the settlements role, and his tactical deception using spreadsheet models and accounts with whited-out text that was invisible to others.  SocGen claims Kerviel used complex program trades with exchange traded funds and swaps for a similar tactical deception.  Leeson's losses made Baring's illiquid and in 1995 the English merchant bank was sold to ING for £1.

On the surface Leeson and Kerviel share enough similarities as a pair to warrant the 'rogue trader' label.  Both had knowledge of sophisticated financial instruments and markets.  Both used this knowledge to make substantial profits for their respective firms.  Both were in teams which faced rapid revenue growth but also with a lack of internal controls: Singapore for Leeson and Delta One for Kerviel.  Both used tactical deception in attempts to escape from adverse trade situations, caused by the misuse of financial instruments, dynamic disequilibriua in the markets, and cascade events.  In Leeson's case, Japan's Kobe earthquake on 17th January 1992 was also a Black Swan event.  Both Leeson and Kerviel have made counter-accusations that the banks' senior management were scapegoating them for larger institutional losses.

One central difference between Leeson and Kerviel is that all game-players are now more aware of 'rogue trader' as a media narrative and symbol of financial villains.  Bloggers posted Kerviel's resume online and registered his name as a website address.  Bouton quickly singled Kerviel out for blame before French authorities also charged Kerviel's manager.  Kerviel countered this with claims that SocGen's senior management was happy with his trading and that the bank had broader problems with its risk management system.  Independent sites such as ReTheAuditors.com also discussed Kerviel's case.

SocGen appointed a Special Committee to investigate Kerviel's trades and to evaluate its corporate governance and risk management systems.  The Special Committee and General Inspection reports found problems with Kerviel which echo post-mortems on Leeson: no supervisor, an inexperienced new manager, problems with intraday positions and high-correlative markets, ignored red flags, and a lack of transparency between middle office and back office functions.  The bank also derisked its internal review by hiring PricewaterhouseCoopers to evaluate SocGen's risk management systems.  The audit firm then derisked itself by de-scoping its report which PwC claims was based on SocGen's internal documents and industry best practices.

Was this an exercise in 'plausible deniability'?  Perhaps.  Did it interest book publishers? Yes, the entrepreneurial small press turned Kerviel's case into several 'quick books' for micro audiences.  Did Kerviel create a new market?  Definately: at a university career fair in May 2008 a Gen Y consultant pitched to me that her Big 4 accounting firm could prevent future Leesons and Kerviels through the automatic control of access rights to critical IT systems.  I countered that whilst this solution would provide audit trails, it might not deal with the 'human factors' that allow failures such as Leeson and Kerviel to (re)occur.

BCF's fine signals some deeper problems in SocGen's corporate governance and risk management systems.  Traders can use knowledge of complex derivatives, options and trading systems for tactical deception.  They may also perceive risk management as a separate function rather than an integral process, although this is changing after the 2007 subprime crisis.  Senior managers who keep changing their stories in a crisis may be stonewalling.  The pressure to make profits can mean that outcomes-based systems are manipulatable according to the outcomes demanded.  In Kerviel's case managers ignored 'red flags' from the Eurex derivatives exchange.  Could Eurex have the independent power to bar traders who reach a high level of 'red alerts' in a given period?  What if Eurex took a solution from nuclear detente and have a 'red phone' line direct to SocGen's internal auditors and external regulatory agencies?

Leeson and Kerviel are proof that traders always face the possibility of large losses from consistent market trades.  Fans of Oliver Stone's film Wall Street (1987) and Michael Lewis's memoir Liar's Poker (W.W. Norton & Co., New York, 1989), which is mandatory reading in many MBA corporate finance classes, can overlook this market reality.  But equally overlooked is a more troubling problem: the differences in promotion pathways and work culture between compliance/legal/risk staff and traders who must live by their next deal regardless if the client blows up.  Gordon Gekko (Michael Douglas) recruits Bud Fox (Charlie Sheen) in Wall Street because Fox is ambitious, risk aware, and his working class roots give him a gritty edge.  Lewis suggests in Liar's Poker that Salomon Brothers traders share a similar outlook.  SocGen's managers promoted Kerviel to junior trader from a compliance role and SocGen's lawyers now believes this risk management knowledge aided Kerviel's tactical deception.  Described by friends as 'honest, working class' Kerviel might be Bud Fox without the 'remorse of conscience'.