Case Study No. 10
Trading Scandal at Société Générale
In January 2008, Société Générale
(SocGen), France’s second largest banking establishment, was a victim of
internal fraud carried out by an employee, Jérôme Kerviel. SocGen bank lost
€4.9 billion (euros) as an immediate result of the fraud. (At the time of the
incident, the euro was worth approximately $1.45.)
In 2007, SocGen was rated the best
equity derivatives operation in the world by Risk magazine. Its internal
control system of checks and balances was world renowned. For example, its
trading room had five levels of hierarchy, each of which had a clear set of
trading limits and controls, checked daily by a small army of compliance
officers.2 In addition, “the bank also [had] a shock team of internal auditors
who descend on a corner of the bank without warning and pull apart its
operations to ensure they conform to bank rules.”3
During the summer of 2000, Kerviel began
his employment at the bank—ironically, in its Compliance Department. Five years
later, he was promoted to a junior trader in the arbitrage desk, which deals in
program trading, exchange-traded funds, swaps, stock index futures trading, and
quantitative trading. Kerviel was responsible for generating profits for the
bank and its customers by betting on the market’s future performance. His first
major win came when he shorted stock of German insurer Allianz and earned the
bank €55,000.
Thanks to his years of experience in the
Compliance Department, Kerviel was an expert in the proprietary information
system SocGen used to book trades. He knew that while the Risk-Control
Department monitored the bank’s overall positions very closely, it did not
verify the data that individual traders entered into the system. Kerviel also
knew the timing of the nightly reconciliation of the day’s trades, so he was
able to delete and then reenter unauthorized transactions without getting
caught.
On November 7, 2007, SocGen received an
e-mail alert from a surveillance officer at Eurex (one of Europe’s largest
exchanges). The message stated that Kerviel had engaged in several transactions
that had set off alarms at the exchange over the past seven months. A SocGen
risk-control expert responded two weeks later indicating that there was nothing
irregular about the transactions. A week later, Eurex sent a second e-mail
alert, stating that they were not satisfied with SocGen’s explanation and
demanding more details. Following another two-week delay, SocGen provided
further details, and both Eurex and SocGen let the matter drop. The SocGen
risk-control expert used information provided by Kerviel and his supervisor as
well as a compliance officer at a SocGen subsidiary as the basis of both of his
replies to Eurex. Kerviel’s supervisor stated that there was no anomaly
whatsoever.
Following the Eurex warnings, Kerviel
took additional steps to cover his tracks by manipulating portions of the
internal risk-control system with which he was unfamiliar. This ultimately led
to the discovery of his alleged fraud.4 On January 18, 2008, Kerviel executed a
set of trades that set off another alarm. This time, upon a more thorough
investigation, a major problem became apparent. As SocGen risk-control experts
carefully reviewed Kerviel’s latest transactions, they were shocked to discover
that the trades had resulted in a market exposure for the firm of €50 billion
(obviously far beyond Kerviel’s trading limit), which, when finally cleared,
resulted in a loss of more than €4.9 billion.
As of this writing, Kerviel is still
under investigation and involved in litigation charging him with using his
insider knowledge to falsify records and commit computer fraud. Prosecutors
suspect his motivation was to boost his income by making successful trades far
beyond his trading limits, thus earning large bonuses (his total salary and
bonus for 2007 was a relatively modest €94,000). Kerviel spent five weeks in
jail but is currently free on bond. He was hired in February 2008 as a computer
consultant by the French firm Lemaire Consultants & Associates; however, he
is said to be “traumatized” by his newfound infamy.
Kerviel admits he took trading positions
beyond his authorized limit to make transactions involving European index
futures. Kerviel told prosecutors, “the techniques I used aren’t at all
sophisticated and any control that’s properly carried out should have caught
it.”5 He insists that he did no wrong and that the bank was fully aware of his
transactions. Kerviel says that he refuses to be made a scapegoat for the
bank’s lapses in oversight. He argues that his superiors tacitly approved his
activities—as long as they were generating a profit. Kerviel had earned a
profit for the bank of nearly €1.5 billion in 2007 by exceeding his trade limit
and executing similar, but successful, trades. Meanwhile, the bank says that
the fraud was based on simple transactions but was concealed by “sophisticated
and varied techniques.”6 If convicted, Kerviel faces up to five years in jail
and fines totaling as much as €300,000.7
The sterling reputation of SocGen was
badly tarnished, and the market value of the firm dropped 50 percent over the
course of just a few months. The bank’s highly respected CEO and chairman of
the board, Daniel Bouton, was put under enormous pressure to step down; this
included requests for his resignation from French president Nicholas Sarkozy.
Bouton eventually resigned as CEO in May 2008, but he remains chairman of the
board.8 In December 2008, European hedge fund GLG Partners entered into an
agreement to acquire the bank in the second half of 2009.9
Several internal and external
investigations of the bank’s operating procedures and internal controls have
been completed. The French banking regulator stated that there were “grave
deficiencies” in the bank’s internal controls and fined it €4 million. The
Banking Commission said that SocGen did not focus sufficiently on fraud
weaknesses and that there were “significant weaknesses” in the bank’s IT
security systems. Another report pointed out that Kerviel’s direct supervisor
was inexperienced and received insufficient support to do his job properly. It
also stated that Kerviel’s fraudulent transactions were entered by an unnamed
assistant trader, thus raising the issue of collusion and indicating even more
widespread weaknesses in internal controls.
Pascal Decque, a financial analyst who
covers SocGen for Natixis (a leading player in corporate and investment
banking), commented, “SocGen was brilliant in [its] achievement, … the world
leader in derivatives. Maybe when you are that good, you think you will never
fail.”10
Questions to Consider
1 Peter Gumble, European editor for
Fortune magazine, comments, “Kerviel is a stunning example of a trader breaking
the rules, but he’s by no means alone. One of the dirty little secrets of
trading floors around the world is that every so often, somebody is caught
concealing a position and is quickly—and quietly—dismissed…. [This] might be
shocking for people unfamiliar with the macho, high-risk, high-reward culture
of most trading floors, but consider this: the only way banks can tell who will
turn into a good trader and who won’t is by giving every youngster it hires a
chance to show his mettle. That means allowing even the most junior traders to
take aggressive positions. This leeway is supposed to be matched by careful
controls, but clearly they aren’t foolproof.”11 What is your reaction to this
statement by Mr. Gumble?
- When trading, you first need to set your
goals and you need to assess your risk. Every strategy needs to have thorough
plan and you need to define on when you should stop trading.
2 What explanation can there be for the
failure of SocGen’s internal control system to detect Kerviel’s transactions
while Eurex detected many suspicious transactions?
- The failure of SocGen is that they
failed to monitor the transactions made by Kerviel. They didn’t take into
account that someone might investigate their internal control system.
Comments
Post a Comment