February 1 2008: 1:13 PM EST
4 things I learned from Société Générale
We still don't know how the infamous French trader managed to build a $72 billion position on the sly, but we have gleaned a few other useful tips.
By
Peter Gumbel, European editor
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| Chief executive Daniel Bouton. |
(Fortune) -- Two weeks after the scandal first broke, we still don't know exactly how Jérôme Kerviel, a lowly 31-year-old trader on the arbitrage desk at French bank Société Générale managed to build a $72 billion position in European stock index futures.
It's also not clear whether the bank will survive the scandal intact: hit by $7 billion in losses, chief executive Daniel Bouton is under enormous pressure to step down, and Paris is buzzing with talk - so far unconfirmed - that archrival BNP Paribas may be looking to launch a takeover bid.
But already, there are four lessons to be drawn from the Kerviel affair:
1. Nobody is infallible.
Société Générale, better known in the English speaking world as SocGen, had every right to be proud of its reputation. Under Bouton's stewardship, it transformed itself from the Cinderella of French banking into a world leader in equity derivatives.
For years that was a hugely profitable business, and SocGen's prowess earned it numerous plaudits, including being named the best equity derivatives operation in the world by Risk Magazine last year. That's fitting because SocGen boasted about excelling at risk management, not just trading. Its internal controls were famously tough: the trading room has five levels of hierarchy. Each of those levels has a clear set of limits and procedures that are checked daily by a small army of compliance officers.
Alongside these regular controls, the bank also has 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. Yet Kerviel was able to circumvent all these controls.
More remarkably, he was able to do so for more than two years, according to his testimony to prosecutors. He was quizzed several times, including once last November after the derivatives exchange Eurex queried one of his positions, but every time he managed to persuade his superiors that nothing untoward was happening (including, he acknowledged, by faking emails from counterparties).
Christian Noyer, the governor of the Bank of France, told a Senate hearing this week that before the scandal broke his inspectors had made some recommendations to SocGen to tighten some of its internal procedures.
But Kerviel has punched a big and potentially irreparable hole in the bank's reputation. "The techniques I used aren't at all sophisticated and any control that's properly carried out should have caught it," he told prosecutors, as if to rub it in.
2. If you hire a bunch of young alpha males and pay them big money to take risks, some will inevitably cut corners.
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 quickly - and quietly - dismissed.
Angela Hayes, a financial services partner at London law firm LG, has been involved in three such cases in the past year alone. In one case, a rogue trader concealed an unauthorized position for three months before being caught.
"People do this not infrequently, and the question is how quickly compliance systems pick it up," Hayes says. "Mismarking" the value of your position, she says "is a classic. It's often only picked up when the individual goes on holiday."
That 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 (see above), but clearly they aren't foolproof. Kerviel only took four days vacation last year, deliberately so as not to be caught out. From his testimony to prosecutors, it's clear he felt inferior to his colleagues about his education - he wasn't a graduate of one of France's Grandes Ecoles. That may well have made him try to impress even harder.
3. $72 billion isn't what it used to be.
Kerviel received a base pay for 2007 of $87,000 before tax and a $435,000 bonus, or half what he was asking for. In his testimony, he says he had actually made an $80 million profit for the bank last year, but couldn't tell anyone because that would have led to his unmasking.
His testimony is self-serving, of course, but what's striking is the disparity between the sums he was earning and the amounts he was allowed to play with in his job. He told prosecutors that his first big career win came early on as a trader, in 2005, when he shorted stock of German insurer Allianz (AZ) and earned the bank $720,000. Under such circumstances, it's easy to see how numbers become so abstract that they bear no relationship to reality.
The $72 billion position he amassed in the end is the equivalent to the gross domestic product of Tunisia. But to Kerviel the whole thing appears to have seemed more like a game. Proponents of financial market globalization like to talk about the huge advances that have been made by innovative financial engineering, such as the advent of exotic financial derivatives of the type SocGen packages, sells and trades.
But taken together with the U.S. subprime crisis - in which U.S. banks packaged thousands of deadbeat mortgage loans into leveraged securities that they then sold on to often unwitting investors - one of the big questions raised by the Kerviel affair is whether the world of finance has lost touch with the real world it's supposed to be financing, and what's needed to bring it back into line.
The total volume of financial derivatives of one sort or another floating around the world greatly exceeds the world's GDP. A scandal of this nature may be just what the doctor ordered to make regulators and the banks themselves ponder whether that's so smart.
4. France is, well, France.
The difference could hardly be bigger: when Britain's Northern Rock ran into trouble last year during the summer credit squeeze, the government rallied to its aid.
In France, by contrast, when SocGen hit the floor, the instinctive government reaction was to put the boot in. Government officials have been tut-tutting to the French press about the bank's conduct, and openly complaining that they weren't informed of the crisis until after SocGen had liquidated Kerviel's position.
President Nicolas Sarkozy this week openly called for CEO Bouton to quit. Moreover, his aides have been stating very publicly that they won't tolerate any attempted takeover bid for SocGen by a foreign bank - and are working hard behind the scenes to coax cross-town rival BNP Paribas into making a move. By doing so, they are breaching European Union rules on open markets.
What's striking is that SocGen is a bank with a wide range of shareholders in France and around the world - but not, as it happens, the French government. Sarkozy has been shaking up a lot of hide-bound traditions in France since he became president last May, but the sort of nationalist, dirigiste approach to business that dates back to Jean-Baptiste Colbert, Louis XIV's finance minister, isn't one of them.
That doesn't make life easier for Bouton and his beleaguered bank. 
