La Grande Illusion

I. La Règle du Jeu

Société Générale SA (“SocGen”) seemed poised to become one of the strongest and most
well-respected financial institutions in Europe. In April 2007, they had acquired 75% of Banka
Popullore in Albania.[1]
Their stock, listed on the Euronext, reached an all-time high of $158.42 a share
on May 4, 2007, shortly following the acquisition of Banka Popullore. Their performance heading into 2008 had been
so strong that Risk Magazine named SocGen the Equity Derivatives House of the
Year.[2] Risk Magazine noted that SocGen has handled
the recent volatility in the market effectively through the use of innovation
and risk management.[3]

Despite these accolades and accomplishments,
SocGen has spiraled downhill since the start of the New Year.  This
article will examine how a rogue trader nearly brought SocGen to its
knees, why lax banking controls allowed it to happen, and how it can be
prevented in the future.

II. Le Crime de Monsieur Kerviel

SocGen hired Jérôme Kerviel in
August of 2000.[4] His life was unremarkable. The son of a hairdresser and a metal shop
teacher, Monsieur Kerviel graduated with a degree in finance from a university in Lyon.[5] He started working in a back office and
middle office, where trades were monitored, before being promoted to junior
trader, with a €100,000 yearly salary.[6] His job was essentially to make bets on which
way certain European stocks would move, namely in trading futures tied to
baskets of stock, such as the Euro Stoxx 50.[7] In short, he was a vanilla trader with
limited authority.[8] He seemed like the last person in the world
capable of pulling off a multi-billion dollar fraud. Yet, that is precisely what Monsieur Kerviel managed
to do.

Placing his actions into context, two intertwined
trends helped shape the environment in which Monsieur Kerviel worked.
These two trends were
the growth of derivatives business and the increased use of SocGen’s
own money to
make these bets on the market, which is known as proprietary trading.[9] SocGen Traders who normally engage in these derivatives markets using other people’s money were encouraged to engage in these
proprietary bets, as SocGen bosses often used the success of these to gauge traders’
success.[10] Oftentimes, traders would briefly exceed their limits imposed on their trading before pulling back, in spite of
mechanisms in place at SocGen that were meant to prevent this kind of behavior.[11]

As a trader, Monsieur Kerviel’s job
was to exploit the differences in the value of different stock markets.[12] His job carried “negligible risk”
with the transactions he carried out.[13] However, in 2005, Kerviel began making transactions
outside of his limited authority. According
to Kerviel, his first trade involved taking a stand on Allianz stock, betting
that the market would drop.[14] Shortly thereafter, the London terrorist attacks
occurred, causing the market to drop and netting Kerviel €500,000 in profits.[15] He continued to make comparable trades by
logging into SocGen’s computer system under different names, entering false
hedging contracts and canceling them before they were settled, inevitably
compiling €1.4bn in profits by the end of 2007.[16] However, he only reported a €55m profit to
SocGen.[17] In spite of the numerous red flags this kind
of trading would normally cause, Kerviel was able to use basic methods such as
false email addresses to keep suspicion at bay.[18] However, those were not the only things that
allowed him to continue making these trades during his time at SocGen.

III. La Fille de L'eau

According to former employees, rivals, and
Monsieur Kerviel, SocGen either was aware or should have been aware of
his activities through internal warning signs.[19] In fact, Kerviel claims that SocGen was aware
of his activities, but it was in SocGen’s interests to close their eyes and let
him carry out these trades.[20] According to two former employees of SocGen, there
was a lack of control over the traders that led to the traders not getting
punished and led to the inspection teams being treated with disdain.[21] Rival executives pointed out that SocGen should
have taken a harder look at his gross trading positions and reconciled its
trading accounts with the bank’s position.[22]However, either SocGen did not carry out
these routine practices or they ignored internal warnings.

There were also warnings from
external sources that would have uncovered Monsieur Kerviel’s unauthorized
activities. On November 7th,
2007, a surveillance officer at Eurex, one of the largest exchanges in Europe, informed
a compliance officer that Kerviel had engaged in several transactions which had
raised numerous red flags.[23] Almost two weeks later, SocGen responded via
email that the after-hours trading was justified due to recent market
volatility.[24] Dissatisfied with the bank’s response, the
officer sent another email demanding details for what was happening.[25] SocGen responded shortly thereafter and the
matter was eventually dropped.[26]

Things began to unravel in earnest in
early January of 2007. Monsieur Kerviel placed
three bets totaling €50bn on three European stock exchange indices.[27] Despite having a €1.4bn profit at the end of
2007, his profits dried up with these bets. On January 18th, the head of SocGen’s investment banking
division received word from compliance officers about a problem with a €30bn
trade in the bank’s equity derivatives division.[28] The ensuing investigation into the trade
revealed Kerviel’s unauthorized trades. Between
the loss from the trade and unwinding his trades, the total cost to SocGen was
eventually tallied at €4.9bn ($7.2bn).[29]

The trades were eventually traced
back to Monsieur Kerviel. He and his
attorney have claimed three noteworthy things in the fallout. First, his attorney claimed that the €4.9bn
loss was not Kerviel’s fault, but was instead SocGen’s fault for unwinding all
of his trades and causing those losses.[30] Second,
his attorney has blasted SocGen for “feeding [Kerviel] to the wolves” in its
public statements.[31] Finally, Kerviel has maintained that he was
carrying out these actions for the profits of the bank, rather than for any
personal gain he might have reaped from these trades.[32] He did not seek to keep any of the bank’s
money.[33]

IV. La Nuit du Carrefour

In the aftermath,
speculation has run rampant as to how all of this was allowed to
happen. Some people have painted Monsieur Kerviel as a technological
whiz kid sophisticated enough to cover his tracks and keep his actions
covert.[34] Others, such as the French Finance Minister, have
criticized SocGen’s internal control mechanisms for not catching and remedying
these frauds sooner.[35] However, because of the timing and fallout from
this incident, three things have come about that could affect SocGen’s future
as well as the future of other trading groups.

First, regarding SocGen itself, the
timing of the unveiling of Monsieur Kerviel’s actions comes at a particularly bad time
for the financial giant. Earlier this
week, SocGen was one of four banks to go to court over money-laundering charges
that the bank helped funnel €82m into Israel in the late 1990s.[36] More recently, SocGen handed over an internal
investigation which stated that over 800 accounts were used by front men or
companies acting on behalf of two brothers in order to channel millions of
euros into real estate deals.[37]  Coupled with Kerviel’s recent actions, these
two sets of allegations call into question the quality and extent of SocGen’s
anti-fraud capabilities.

Second, because of these swirling
accusations, losses, and declining stock price, rumors have been spreading
about a possible takeover bid. Eight
years ago, SocGen successfully fended off a takeover bid from its rival, BNP
Paribas.[38] However, because of these continuing problems
facing SocGen, its rivals are once again licking their chops for a possible
takeover. While HSBC is considered to be
the most logical fit to buy SocGen, other financial institutions such as BNP
Paribas, Credit Agricole, and Intesa Sanpaolo may become players for all or
part of SocGen.[39]

In an odd contrast to SocGen’s
decline, Monsieur Kerviel has become a celebrity for his actions around the
world. An official website, http://www.jeromekerviel.com, offers links
to a variety of items, such as t-shirts featuring slogans like “I Bet on Jerome”
and “I Am Jerome Kerviel’s Girlfriend” along with a variety of links to
products on Amazon.com which focus on gambling and the stock market. Despite facing a variety of charges, Kerviel
has managed to attract the sympathy of many who view him as a Robin Hood-like
figure.

Third, this incident has helped an
emerging field of science, called neurofinance, gain popularity. In neurofinance studies, volunteers allow
scientists to map their brains, monitor heart rates, body temperature, and
respiration while the volunteers engage in trading.[40] According to some of these studies, when
individuals engaged in trading are faced with losses, they may seek to take
more risks, rather than fewer risks, in an attempt to recover those losses.[41] On occasion, the brain images of traders are
almost indistinguishable from drug addicts.[42] One important message from these studies is
that investors are not always rational in making decisions with their money.

V. Finis

After the dust has settled from this
mess, one final question must be addressed: how can this be prevented from
happening again? Despite SocGen being
one of the most reputable and successful financial institutions, a simple vanilla
trader was the catalyst for its catastrophic near-collapse. Based on the facts and allegations, SocGen
had everything they needed in place to put a halt to Kerviel’s activities
before they spun out of control, yet his trading was allowed to reach critical
mass.

The only conclusion that
I can come to is that SocGen’s internal regulations
were faulty. Either they were complacent
in letting Monsieur Kerviel carry out these trades or they were ignorant of basic
internal mechanisms that would have alerted them to his fraud. Considering SocGen is a publicly traded financial
institution which not only engages in derivatives markets trading, but also in
things such as retail banking, they have fiduciary duties to their shareholders,
depositors, and other clients which they clearly put to the side in condoning
or ignoring Kerviel’s ongoing fraud. The
fact that such a reputable institution ever got to this point in the first
place is shocking and appalling.

Thus, the only solution
to this is more effective regulation. SocGen’s
incentives were aligned to promote enormously risky trading and those trades
backfired on them. This fraud
jeopardized countless retail and private bank accounts. While it would be a drastic measure, splitting
SocGen’s retail and private banking from its investing branch would be one of
the most effective protections to give depositors. Failing that, more stringent regulations both
by outside parties and by the SocGen itself can minimize the potential impact
of these trades if they happen again. If
the brains of traders can be comparable to those of drug addicts, their
rationality is clearly in doubt.

The lesson of SocGen is
clear. Banks need to more effectively protect
themselves from enormously high risks by setting better controls over their
investors. Furthermore, outside regulation
is needed to ensure compliance from these banks.


[1]Societe Generale Acquires 75 pct of Banka
Popullore in Albania
, Forbes.com, Apr. 16, 2007, http://www.forbes.com/business/feeds/afx/2007/04/19/afx3628998.html.

[2] Equity
Derivatives House of the Year –
Société Générale, Risk Magazine, Jan. 2008, http://www.risk.co.uk/public/showPage.html?page=685494.

[3] Id.

[4]Transcript: Interrogation of Jérôme Kerviel, INT’L HERALD TRIB., Jan. 30, 2008, http://www.iht.com/articles/2008/01/30/business/transcript.php.

[5] Doreen Carvajal and James
Kanter, A Quest for Glory and a Bonus
Ends in Disgrace
, N.Y. TIMES, Jan. 29, 2008, §C, at 1.

[6] Id.

[7] David Gauthier-Villars,
Carrick Mollenkamp, and Alistair MacDonald, French
Bank Rocked by Rogue Trader
¸ WALL ST. J., Jan. 25, 2008, at A1.

[8]
John Leicester, Rogue Trader: a “Poised,
Calm, Thoughtful Young Man” Who Made Few Waves
, WallSt.net, Jan. 25, 2008, http://www.wallst.net/news/news.asp?Source=APNEWS&id=96420&title=Rogue%20trader:%20a%20.

9] Nelson D. Schwartz and
Katrin Bennhold, A Trader’s Secrets, a
Bank’s Missteps
, N.Y. TIMES, Feb. 5, 2008, §C, at 1.

[10] Id.

[11] Id.

[12] Martin
Arnold, Peter Thal Larsen, Peggy Hollinger, John O’Doherty and Richard Milne, How Kerviel Exposed Lax Controls at Société Générale, FT.com Comments & Analysis, Feb. 7,
2008, http://www.ft.com/cms/s/0/927fe998-d5b2-11dc-8b56-0000779fd2ac.html.

[13] Id.

[14]Transcript: Interrogation of Jérôme Kerviel, INT’L HERALD TRIB., Jan. 30, 2008, http://www.iht.com/articles/2008/01/30/business/transcript.php.

[15] Id.

[16] Martin
Arnold, Peter Thal Larsen, Peggy Hollinger, John O’Doherty and Richard Milne, How Kerviel Exposed Lax Controls at Société Générale, FT.com Comments & Analysis, Feb. 7,
2008, http://www.ft.com/cms/s/0/927fe998-d5b2-11dc-8b56-0000779fd2ac.html.

[17] Id.

[18] Id.

[19] Transcript:
Interrogation of Jérôme Kerviel
, INT’L HERALD TRIB., Jan. 30, 2008, http://www.iht.com/articles/2008/01/30/business/transcript.php; Martin Arnold, Peter Thal Larsen, Peggy
Hollinger, John O’Doherty and Richard Milne, How Kerviel Exposed Lax Controls at Société Générale, FT.com
Comments & Analysis, Feb. 7, 2008, http://www.ft.com/cms/s/0/927fe998-d5b2-11dc-8b56-0000779fd2ac.html.

[20] Transcript:
Interrogation of Jérôme Kerviel
, INT’L HERALD TRIB., Jan. 30, 2008, http://www.iht.com/articles/2008/01/30/business/transcript.php.

[21] How Kerviel Exposed Lax Controls at Société Générale, FT.com Comments & Analysis, Feb. 7,
2008, http://www.ft.com/cms/s/0/927fe998-d5b2-11dc-8b56-0000779fd2ac.html.

[22] Id.

[23] Nelson D. Schwartz and Katrin Bennhold, A Trader’s Secrets, a Bank’s Missteps,
N.Y. TIMES, Feb. 5, 2008, §C, at 1.

[24] Id.

[25] Id.

[26] Id.

[27] How Kerviel Exposed Lax Controls at Société Générale, FT.com Comments & Analysis, Feb. 7,
2008, http://www.ft.com/cms/s/0/927fe998-d5b2-11dc-8b56-0000779fd2ac.html.

[28] Id.

[29] Id.

[31] Id.

[32] Transcript:
Interrogation of Jérôme Kerviel
, INT’L HERALD TRIB., Jan. 30, 2008, http://www.iht.com/articles/2008/01/30/business/transcript.php.

[33] Doreen Carvajal and James Kanter, A Quest for Glory and a Bonus Ends in
Disgrace
, N.Y. TIMES, Jan. 29, 2008, §C, at 1.

[34] Peter Allen, Phone
Records Could Be Key to Kerviel Case
, Telegraph.co.uk, Jan. 29, 2008, http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/01/28/bcncruise128.xml.

[35] Emmanuel Georges-Picot, French Finance Minister Says Societe Generale Controls Failed Before
Trading Loss
, WallSt.net, Feb. 4, 2008, http://www.wallst.net/news/news.asp?Source=APNEWS&id=103462&title=French%20finance%20minister%20says%20Societe%20Generale%20controls%20failed%20before%20trading%20loss.

[36] Money-Laundering Case Goes to Trial, THE
JERUSALEM POST, Feb. 5, 2008, http://www.jpost.com/servlet/Satellite?cid=1202064583645&pagename=JPost%2FJPArticle%2FShowFull.

[37] Catrina Stewart, 2 Russians Seen in SocGen Fraud Case,
THE MOSCOW TIMES, Feb. 7, 2008, at 7.

[38] Martin
Arnold, Peter Thal Larsen, Peggy Hollinger, John O’Doherty and Richard Milne, How Kerviel Exposed Lax Controls at Société Générale, FT.com Comments & Analysis, Feb. 7,
2008, http://www.ft.com/cms/s/0/927fe998-d5b2-11dc-8b56-0000779fd2ac.html.

[39] Stephen Taylor, Societe Generale Rises on Speculation Bank
Is Target
, Bloomberg.com, Feb. 6, 2008, http://www.bloomberg.com/apps/news?pid=20601087&sid=aSC5LNOyh8bw&refer=home.

[40] Jenny Anderson, Craving the High that Risky Trading Can
Bring
, N.Y. Times, Feb. 7, 2008, §C, at 1.

[41] Id.

[42] Id.

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