How did Societe Generale Lose Billions?

The Kiss of Judas by Giotto di Bondone

When trading for a firm’s own account becomes the major activity, it ceases to be ‘trading’ and becomes ‘gambling’ (Peter Drucker, 2002). This statement by the father of modern management proves its worth yet again as Societe Generale also known as Soc Gen had racked up a €4.9 billion ($7.2 billion) loss as a result of unauthorized bets on futures linked to European stockmarkets in January 2008. As a result of the revelation of the fraud, SocGen’s shares were temporarily suspended on January 24th. Soc Gen at the time at the time the fraud was uncovered was France’s second-largest bank by market capitalization. The bank had previously announced a €2.05 billion ($3 billion) write-down due to its exposure to subprime-related assets.

The cause of the heavy losses incurred by Soc Gen ironically stems from just a single trader from a small town in Brittany named Jerome Kerviel. Soc Gen had previously claimed that Kerviel had been covering his tracks by creating many fictitious transactions to hide his large exposed trading positions which amounted up to €50 billion. Furthermore, these positions though large as they was were unauthorized and remained unchallenged until the beginning of 2008 when it was already too late. According to the Economist (January 31st 2008), Kerviel was placed under formal investigation for abuse of trust, breaching computer security, and falsifying information on January 24th.

The question now is whether Kerviel is truly an evil genius that hacked his way into €49 billion of losses for SocGen or whether the bank itself had an inadequate security system that did nothing to prevent Kerviel from trading recklessly. Surprisingly, even for a bank that dedicated 26 reassuring pages in its annual report in 2006 for its top-notch risk management practices, the answer seems to be the latter of the two. While Mr Daniel Bouton, SocGen’s chairman and co-chief executive was quick to say that Kerviel had an extraordinary talent for hiding what he did from the bank’s watchdog.

However, records of Mr Kerviel’s activities seem to contradict Mr Bouton’s stand on the whole issue as Kerviel’s trading activities had already trip the banks security alarms way before January 2008. According to the head of SocGen’s investment arm, states that Kerviel said that he made a ‘mistake’ whenever he was questioned concerning his trading activities. To add to that, Europe’s largest futures exchange, Eurex, had contacted SocGen on the ‘oddities’ in its trading patterns in the late 2007 which according to Paris persecutors referred to trading positions done by Kerviel (Economists, January 31st 2008).

According to the same source, there were a few blind spots that prevented the detection of Kerviel’s unauthorized trading activities. The first was that SocGen’s security system focused on the net position of traders instead of their gross trading activities. This enabled Kerviel who had no defined gross exposure limit to set up fictitious portfolio of trades that supposedly match his speculative positions he was taking. By doing so, his net exposure stayed off SocGen’s security radar.

The second blind spot was that the margin data from Eurex showed only consolidated positions made by the entire bank. Due to the size of SocGen, the positions that Kerviel took were not of a drastically different magnitude than the volume of trades expected of other big banks. This means that although the margin calls on Mr Kerviel’s trades which according to the Economist January 31st 2008, would be a large figure of around €2.5 billion on a €50 billion position, its consolidated accounts seems to be relatively ‘normal’. Consequently, SocGen’s watchdogs did not see what was attributed to each trader which would have alerted the bank on Kerviel’s huge gross positions.

There were other aspects that would have revealed Kerviel’s malicious activities. The fictitious portfolio that he set up did not only comprise of over-the-counter transactions with other big banks but also trades with other parts of SocGen. Furthermore, Kerviel’s limited holidays and late nights should also have raised some concern to his activities. While Mr Bouton’s claims that Kerviel had previously worked in the back-office and was therefore familiar with the systems of controls, Kerviel had proved that the internal security system of SocGen was inadequate and could be easily outfoxed by a rogue trader.



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