Rogue Traders a Nightmare Scenario for Finance CEOs

Report: Jerome Kerviel says his bosses were aware of his financial risk taking.

February 9, 2009, 5:11 PM

Jan. 29, 2008 — -- How much did French bank Societe Generale know about the major risks that trader Jerome Kerviel was taking?

Well, Kerviel told investigators that he believes his bosses were well aware of his risk taking but turned a blind eye as long as he earned money, a judicial official said Tuesday, according to the Associated Press.

"I can't believe that my superiors were not aware of the amounts I was committing, it is impossible to generate such profits with small positions," according to excerpts of his police testimony published in Le Monde newspaper.

Kerviel told investigators of efforts to mask his massive transactions, but he said his bank must nonetheless have noticed something suspicious.

"The techniques I used were not at all sophisticated, and any correctly conducted check should be able to detect these operations," he said, according to the testimony in Le Monde that the AP confirmed with a prosecution official.

Kerviel also insisted that his top concern was "earning money for my bank."

"As long as I was earning cash, the signs were not that worrisome," he said. "As long as you earn money and it isn't too obvious, and it's convenient, nobody says anything."

A lawyer for Societe Generale said the bank was "a victim of someone who lied, who cheated."

"When you are questioned by police or judges, you have the right to lie," lawyer Jean Veil told RTL radio.

Like countless other junior traders around the world, 31-year-old Kerviel was eager to make headlines within the trading community, and turn his six-figure salary into an exponentially larger one. But unlike others, Kerviel made international headlines for entirely different reasons, as the man behind the world's largest financial loss in history.

Last week's headlines blared the news that Kerviel racked up more than $7 billion in trading losses for the French bank Societe Generale, sealing his worldwide infamy and leaving him to face the possibility of up to seven years in prison for breach of trust and charges of unauthorized computer use.

Kerviel's actions also shed light on the huge ramifications faced by the world's leading financial institutions, whose traders run awry. In an industry that can reward risk with exponential returns, the specter of a rogue trader looms large.

Most financial leaders believe they have provisions in place to keep such actions from occurring. But that doesn't mean they aren't worried about the possibility of rogue trading, however small the possibility might be.

"I am sure that every firm is looking at their procedures and are trying to figure out how someone can circumvent them," said a senior management official at one of Wall Street's largest banking firms, who asked that his name not be used. "All throughout history, there have been one-off incidents of fraud but not of this magnitude."

The scandal has been the talk of the banking and finance community since it was first reported last week. As the world's top financial minds gathered at the Annual World Economic Forum in Davos, Switzerland, the theme, for at least one day, changed from talk of a possible U.S. recession to talk of a possible meltdown of one of Europe's largest banks.

"I am sure the industry will use it as a learning lesson, but like all frauds, there will be a new fraud that somehow will take place down the road, with even a smarter culprit," said the Wall Street official.

Soaring earnings on Wall Street have left many to describe the last five years as a new gilded age. Money was easily flowing, deals were constantly being signed.

As record revenues rolled in, Wall Street's top banks rewarded their bankers handsomely in hopes of keeping poachers away and maintaining competition among colleagues on trading desks.

And as risk seemed to only offer greater rewards, those who were risk adverse were not always rewarded. Those who brought in highly profitable accounts and transactions were.

Even since the ongoing subprime mortgage and credit crisis, Wall Street firms paid out their highest bonuses to date in 2007, averaging some $33.2 billion, according to the New York State Comptroller's Office, up from $23.9 billion in 2006.

It's a trend that has had some experts nervous for a while, and now we know why.

"There's a sense of a cavalier Wild, Wild West mentality in finance, believing that, somehow, markets will always right themselves," said Jeff Sonnenfeld, senior associate dean at the Yale School of Management.

Sonnenfeld has described the trend of traders ratcheting up their risk level in hopes of greater returns as "a generation that lost its way between knowing the difference between courage and recklessness."

He said many Wall Street traders are not given the appropriate oversight from their bosses, the same scenario that led to Kerviel's misdealings.

"His drive was to be something that he wasn't," Sonnenfeld said.

Societe Generale continues to reveal details of just how Kerviel began making fraudulent transactions at the end of 2006 — spending late nights at the office, hacking into computer systems and stealing log-in codes to override certain trades.

All major banks have risk and compliance offices, leading many to wonder how, in an age of financial transparency, an institution such as Societe Generale could allow such a failure in checks and balances.

One has to look back at Kerviel's initial job at the bank to start putting the first pieces of the puzzle together. In 2000, Kerviel began working in Societe Generale's back office, which tracks and monitors trade executions.

For a bank, bringing someone from its back office into its trading area is a very sloppy decision, according to many experts.

Banks are multifaceted, with many departments. In addition to taking positions on trades, they provide a dealing, clearing and payment function, leaving them with many potential areas where things can go awry.

Kerviel, or "Evil Knievel," as some have called him, for his mastery of deceitful illusion, was able to use his knowledge of how trades are approved to evade detection.

Today, checks and balances at most firms include back offices and centralized clearings where more than one person has to sign off on an execution.

But as the Kerviel saga unfolds, it's apparent that there are still loopholes.

The sheer size of trading desks at major financial institutions, such as Citigroup, Lehman Brothers and, yes, Societe Generale, makes it easier for a rogue trader to slip between the cracks.

Their every move isn't as easy to observe. A sudden change in behavior could go unnoticed.

"In a big bank, superiors get moved around a lot, so they don't have that much time to get to know someone," said a major hedge fund manager, who asked that his name and firm not be revealed.

One red flag to watch for: "You do start to worry when you see someone working late hours alone," said the hedge fund manager.

And that is exactly what Societe Generale said Kerviel had done — working late hours, hacking into various computer systems.

Both Societe Generale and Kerviel's legal team agree that Kerviel did not profit from his multibillion-dollar bet on European stock markets. Instead, he simply wanted to be seen as a better trader. He apparently fell under the pressure to succeed in order to receive a greater bonus.

While trading and investment banking jobs come with immense pressure and countless all-nighters at the office, they also usually come with some nice compensation. According to a recent New York Times report, in 2006, first-year associates with a business degree could expect a salary in the range of $200,000 to $270,000. A first-year financial analyst, just out of college, could expect to make $105,000 to $145,000.

Kerviel's salary is said to have been $147,000 — a fortune to some, but a mere pittance when compared with some of the industry's top earners.

For the executives who oversee large stables of traders, emphasizing caution regarding risk is a tricky proposition. While risk is a very important element in banking, knowing when to back away can be equally, if not more, rewarding in the long term.

And for CEOs, one of the keys to managing risk is keeping tabs on a company's financial positions and its traders. The best method for knowing when to back away may be to know exactly when one of your traders has gone too far.

Sonnenfeld points to J.P Morgan CEO Jamie Dimon as a perfect example of a true Wall Street maverick.

Last spring, just a few months before most banks began taking on massive losses stemming from the subprime and credit market defaults, Dimon, unlike his counterparts at other firms, "rolled up his sleeves and announced that he would be spending the summer examining where the firm's positions were," Sonnenfeld said. "And if he didn't understand it, then he was going to get out. And that was a breathtakingly brilliant move. And it showed true leadership."

J.P. Morgan did take a write down of more than $1 billion in fourth quarter from its subprime exposure, but it was a fraction of what rivals Citigroup and Merrill Lynch took.

Indeed, while Citigroup's Chuck Prince and Merrill Lynch's Stan O'Neal lost their jobs over their subprime exposure, Dimon has kept his and has been able to keep the bank in the black for the fourth-quarter and full year.

Perhaps that is why he seemed the most approachable, if not carefree, financial chief at Davos this year.

With reports from the Associated Press