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 7^th, 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.