When Nick Leeson brought about the collapse of Baring’s Bank in 1995, Société Générale, one of France’s most prestigious financial institutions, was among the many organisations that introduced rigorous checks and balances to prevent anything similar happening to them. Last month they discovered the hard way that their supposedly foolproof system was easy to fool when a junior trader, Jérôme Kerviel, exposed SocGen to a potential loss of a staggering 50 billion Euros, more than the entire value of the bank, and roughly equivalent to half of France’s gold and currency reserves, or the entire annual French budget deficit.
Like Leeson, Kerviel gambled on what are known as “futures”, more accurately, futures contracts, an agreement to buy or sell an item, usually shares or commodities, at a specific price at a specific time. Such contracts are an integral part of trading in what are known as equity derivatives, agreements giving rights or obligations linked to a company’s underlying assets or liabilities.
If the trader correctly predicts the movement in prices, be it up or down, he or she makes a profit. Gains may be dramatic, because typically a futures contract can be secured for an outlay of about a tenth of its quoted value, and never need be fully purchased at all. The problem comes when the trader’s forecast is wrong, and they make a loss. Their exposure is often open-ended, up to the entire value of the shares or commodities. Most banks balance bets that a particular stock market will rise with similar sized bets that it will fall, making money on the margins and on the interest on the funds they invest in futures on behalf of their clients.
Like Leeson, however, Kerviel failed to cover his bets. It is alleged that he created fictitious clients – just as Leeson had done – so that he could trade as though setting up deals on their behalf. Kerviel allegedly disguised his phantom hedges by deleting fictitious transactions just ahead of supervisory checks, then reinstating them on the system. He had the necessary expertise because he had previously worked in the bank’s back office, where he learned everything there was to know about risk controls.
Banking experts have identified an apparent flaw in SocGen’s verification process, alleging that Kerviel remained undetected because there was no trading limit on his gross position. So long as the volume of his short term bets closely matched his long term bets, or at least kept below the limit set on his net position, no alarm bells would ring.
Others remain highly sceptical that Kerviel could have deceived SocGen’s security system for more than a year unless the management had turned a blind eye to his activities, particularly after last November, when the German Eurex market asked questions about what he was doing. For a time, Kerviel continued to record substantial gains, enough to earn him an (unpaid) bonus of 300,000 Euros for 2007, and make a major contribution to the departmental surplus that would have enhanced the bonuses of many other staff. Indeed, there are serious suggestions that Kerviel panicked at the size of his profit, which at one point stood at more than 1 billion Euros, and made reckless bets against the market trend in an effort to reduce it, an exercise which suddenly rebounded on him until he was left with a 2 billion Euros black hole.
Questions have been raised about when SocGen first discovered the scale of the problem, fuelled by the sale by a board member on January 11, Kerviel’s 31st birthday, of millions of the bank’s shares. It cost SocGen another 3 billion Euros to settle Kerviel’s bets in a falling market, and many senior banking figures – although not the French President, who was kept completely in the dark – became aware of what was going on. The temporary meltdown of international markets may be attributable to other banks anticipating falls triggered by SocGen’s wholesale disposal of its futures contracts and selling shares to reduce their own potential losses.
Meanwhile, “Risk”, the self-styled leading financial risk management magazine, with immaculate timing, had just announced its equity derivatives house of the year. The winner? You guessed it – Société Générale.
From our February 2008 e-newsletter
