After a rogue trader cost the French bank €5 billion (equivalent 7.1 billion americanos), many are left to wonder about the lucrative but risky equity-derivatives trade. One of the biggest frauds in financial-services history apparently was carried out by a 31-year-old trader in Société Générale's Paris headquarters, whom multiple news sources have identified as Jerome Kerviel. The trader "had taken massive fraudulent directional positions"—bets on future movements of European stock indexes—without his supervisors' knowledge, the bank said. Because he had previously worked in the trading unit's back office, he had "in-depth knowledge of the control procedures" and evaded them by creating fictitious transactions to conceal his activity.
The fraud was discovered Jan. 20, a Sunday, which meant Société Générale had to start unwinding the positions Jan. 21 just as global equity markets were tanking on fears of a U.S. recession. "It was the worst possible time," says Janine Dow, senior director for financial institutions at the Fitch (LBCP.PA) ratings agency in Paris. SocGen, which also announced a nearly $3 billion 2007 loss related to U.S. mortgage-market woes, has had to seek a $5.5 billion capital increase and could even become takeover prey.Previously, Double-Digit Growth
While those facts seem fairly straightforward, a host of troubling questions still need to be answered: How could SocGen, which ironically was just named Equity Derivatives House of the Year by the financial risk-management magazine Risk, have failed to detect unauthorized
trading that it acknowledges took place over a period of several months? Do banks need to tighten the controls put in place after rogue trader Nick Leeson brought down Barings Bank in 1995? Or is the red-hot business of equities-derivatives trading just too tricky to control?SocGen's equities-derivatives business, the biggest at any institution in the world, has posted double-digit growth the past eight years and until now has been hugely profitable. Fitch estimates the business generated about $1.7 billion in profits during 2006, or about 20% of the bank's net earnings. Backed by elaborate algorithmic models, trading instruments with exotic names such as Himalaya and Altiplano have generated an average 40% return on equity for the bank, more than twice the rate for its retail banking business.
Yet SocGen's derivatives operation is relatively small, with fewer than 2,500 employees including about 300 traders and roughly 750 middle- and back-office employees, according to a 2006 investors' presentation by the bank. The rogue trader apparently spent several years in a back-office job before realizing a long-held dream of moving to trading.
An Inevitable Scandal?
Maintaining strict separation between inherently risky trading activities and careful back-office controls is a key tenet of banking regulation, says Axel Pierron, a Paris-based consultant with Celent, a financial-services advisory group specializing in information technology. But, Pierron says, "In derivatives trading, there's not as strong a separation between trading and back office as in other parts of the bank." Letting employees move from the back office to the trading floor is uncommon but generally not prohibited by banking regulations or banks' own rules, Pierron and other banking specialists say.
Some risk-management experts contend that such a scandal was inevitable, given the global boom in trading exotic securities. "This stuff happens more than people may like to admit," says Chris Whalen, director of consulting group Institutional Risk Analytics. Banks increasingly are moving away from traditional banking into riskier trading activities, he says. SocGen's problem 
was "a rogue business model, it's not a rogue trader."
Yet others point out that SocGen's risk-management practices were some of the best in the industry. "The control procedures that SocGen had in place are much better than those at Barings," says Richard Portes, a professor at the London Business School. "Every bank will be reevaluating their procedures, but it's not clear if there are ways to improve them. There hasn't been a broad failure of risk management across the board, just one guy who knew how to beat the system."
Although SocGen is the global equity derivatives leader, other banks are heavily involved in the business, including the global No. 2 player, crosstown rival BNP Paribas (BNPP.PA), German giant Deutsche Bank (DB), and New York-based Goldman Sachs (GS). The French banks got a huge head start in equity derivatives because of sophisticated mathematical models developed at French universities. Now, the math for SocGen is looking ugly indeed.
Next Week: The CFTC and SEC: Making Société Générale Look Like NASA
Hat tip for the original story to BusinessWeek: Société Générale's Fraud: What Now?
Hat tip for 'creative' input to: rasputin, meg-abear, sean_of_the_zurich_gnomes, rodd saito, and denverdave.
