SocGen's risky business

This week, the focus of the investigation into the multi-billion-euro rogue trader scandal at Societe Generale should widen. The bank will continue to portray 31-year-old trader Jerome Kerviel as a young hothead arriviste who pulled the wool over the eyes of his colleagues -- and some of it will be true. But this lone-wolf excuse is specious.

A culture of risk

It is more than a simple story of devil-may-care high rolling and protocol circumvention. Bets can spin out of control -- ask any casual poker player -- but Kerviel's superiors will need to explain an employee under their watch managed to rack up 7 billion euros in debt before anyone noticed. The scale of the loss shows that the bank's internal risk controls were, at best, woefully inadequate, at worst, non-existent.

"Such schemes are only conceivable in a very lax risk environment where back-office, middle-office, and front-office functions are weakly segregated (if at all), and in a bank that brings far too little independent oversight to bear on its trading unit," writes Louis Gagnon, a professor of finance at Queen's University's School of Business and a former senior risk manager at Royal Bank of Canada. He adds that it is not difficult to imagine who, between risk takers and risk managers, had the upper hand at Societe Generale.

Thus the ultimate responsibility for the fiasco goes all the way to the top. Kerviel's immediate superiors have already been culled, but the board has surprisingly rejected the resignations of Chairman Daniel Bouton and Chief Executive Philippe Citerne, who now have to guide the bank out of this mess. They will paint Kerviel as a mysterious monster, a lone operator who spiralled out of control, but this is absurd casuistry. The rogue trader was the product of an environment where risk taking was embraced -- even encouraged -- as long as it made money for the bank.

Failure in four areas

Bouton and Citerne look to have failed in four areas:

Controls on employee mobility: Societe Generale's management failed to implement controls preventing employees from being reassigned to the trading floor after spending time working in the back office, which is responsible for detecting fraud. Kerviel, who was promoted to the bank's Delta One products team in Paris after over four years working in the company's compliance department, knew how to hide huge cumulative trading losses from the bank's risk reports by submitting fake offsetting counterparty trades to the back and middle office. He would often get notified of his large positions by the back office and, each time, he would submit fictitious offsetting counterparty trades to eliminate these exposures.

Security failures:  Societe Generale says that Kerviel managed to circumvent internal controls by using stolen computer access codes. Kerviel claims the bank must have known what he was doing because of the profits he had generated previously, and suggests his bosses turned a blind eye as long as he was not in the red. 

Lack of communication: There was no mechanism at Societe Generale to alert management about abnormal transactions by individual traders.

Looking in the wrong place: Compliance officers clearly failed to look at the entirety of Kerviel's trading activity, or his "gross positions".  It seems they studied only his net positions, which show account balances but not the positions that may have offset one another.

Be more like Goldman?

Goldman Sachs, which last year escaped most of the bond market turmoil plaguing fellow brokers by taking a short position against the mortgage market, is a company with a much-admired set of risk controls.

Bloomberg columnist Michael Lewis attributes Goldman's avoidance of the sub-prime squalls last year to ex cathedrae pronouncements that offset risky trades. "The only difference between Goldman and everyone else was that Goldman had, in effect, an entirely separate enterprise, sitting on top of the firm, with the power to reverse the judgment of its own supposed experts in various markets. They were able to do this, apparently, without ever saying a word about it to their own traders. Instead of telling the fools trading sub-prime mortgages that they are wrong, and that they should unwind their positions, they simply offset their trades."

The actions of Goldman's top brass are a perfect illustration that risk management is as important in investment bank leadership as risk taking, and that transparency and proper controls are among a bank's most valuable assets in good times and lean.