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Rogue Trader Soc Gen Case Study

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Autor:  anton  16 January 2011
Tags:  Trader
Words: 2806   |   Pages: 12
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Kerviel - New King of the Rogue traders

How Why and Implications surrounding his actions

Word Count – 2,439

SOC GEN Case Study

Leeson, Iguchi, Rusnak….and now Kerviel has been unearthed as the new king of the rogue traders. His losses dwarfed that of Nick Leeson (Barings), John Rusnack (AIB) and Toshihide Igichu (Daiwa) combined, with his losses amounting to €4.9bn. Worldwide financial institutions do not seem to have captured the risk surrounding rogue trading and implemented efficient controls to eradicate or minimise this risk but at the same time are aware of the enormity of the potential problems that arise from this activity. The revelation of the scandal is the biggest of its kind in history and unfortunately for Kerviel and Soc Gen, was at a time when the European stock markets were at there lowest since the catastrophic terror attacks on September 11th 2001.

Mr Kerviel was working within the arbitrage Equity derivatives group at the time he was taking unauthorised positions. As the markets fell, losses soon increased which encouraged further bets in which the value of the bet was insignificantly immaterial in the eyes of Kerviel, creating a snowball effect.

This case study we will identify the underlying reasons as to why Mr Kerviel found it necessary to carry out this fraudulent activity and how he accomplished this. We will also analyse Soc Gen’s reaction and response to his activities and did they take the appropriate steps to overcome these? And finally, what would have been the outcome if this was uncovered as a rogue trading scandal resulting in a profitable position rather than a €4.9bn loss?

Jerome Kerviel started work in 2000, working in a number of roles where he learnt about the banks processing and control procedures. Mr Kerviel had an ambition to work within a trading role which was fulfilled in 2005. Mr Kerviel was promoted to an arbitrage trading role perceived as a very low ranking position within the trading hierarchy.

His freedom of investment within this role was minimal which may have lead him to believe that Soc Gen did not have the confidence in his trading capabilities, therefore restricting his ability to gain his much pursued recognition within the company as a �top trader’. This thirst for recognition was instigated by the high pressure environment surrounding Mr Kerviel. The trading industry could be described as �cut-throat’ in which each trader’s performance is based solely on their financial gains. Due to Mr Kerviel’s role, the potential gain he could make was always lower than that of an experienced or superior trader as they have a role with greater autonomy.

Financial reward was not his main incentive but within the industry success is gauged by monetary bonuses. These experienced traders were earning 10 to 20 times the amount of his salary in bonuses and as identified above, Kerviel’s role in the arbitrage department did not enable him to make these supernormal profits which restricted his freedom to invest, hampering his motivation.

A question you may ask is why was he able to generate such huge profits under the noses of his colleagues and higher level management?

Kerviel believed the management closed its eyes as to how he did it and how he bet. As long as profit was made, it was irrelevant how. (O’Doherty, FT Feb. 4th).

It is hard to disagree with the above statement as Soc Gen invests billions of shareholders funds across the market, so strict controls are imperative. So how could a company which is prided upon its stringent controls not recognise the €1.4bn positive position Mr Kerviel held in December 2006?

To enable Kerviel the opportunity of obtaining these supernormal profits comparable to those of colleagues, he started taking bets outside his authorised fields. Mr Kerviel’s extensive knowledge of back and middle office operations proved to be his underlying advantage in outmanoeuvring the controls in place. He was able to do this by embezzling colleague’s passwords and forging hedge documents. The existing controls failed to spot Kerviel’s transactions as they superficially showed to have a �low residual risk’ therefore no cause for concern was raised by management from risk perspective.

EUREX, Europe’s largest derivates exchange raised questions in November upon a number of trades carried out by one Mr Kerviel (Lagarde, FT, 2008). It raises serious doubt into the integrity of management within Soc Gen. If a reputable source such as Eurex identify any concerns; it must be common practice to investigate any case rigorously. If Mr Kerviel’s position was investigated fully at the time, surely his unauthorised trades would have been recognised. Did management identify these anomalies and “close its eyes” due to his profitable position?

It is very likely that Soc Gen IT security staff were conscious of their vulnerability since this has been one of the main audit findings in most, if not all financial institutions over the past 3 years and many organizations have acted to address this gaping hole in their organizational security (Macleod 2008). Either the issue had not been identified by the auditors or it had not been addressed by IT Security. Who knows, we can only guess. This vulnerability surrounding IT security seems to be a pragmatic reason why this was allowed to happen.

Reports lead us to believe that Mr Kerviel did no take any holidays throughout 2007.

“It’s the first rule of internal control. A trader who takes no holiday is a trader who doesn’t want leaves his books to anybody.” (O’Doherty, FT Feb. 4th).

It is extremely questionable that management did not notice this, in particular his line manager. Although this could be perceived as a keen employee from an external point of view, it is likely to be for reasons somewhat more suspicious. Not only is this negligent management, it is also to do with inadequate controls within HR as all employees at all levels should be required to take a significant leave period. This has been recently researched by the UK Regulatory standards (FSA) to implement a statutory 2 week leave period for all traders in the wake of this recent event. This is a proposition Soc Gen and the AMF must look at considering. (Hughes C, FT 11th March)

Suspicions arose on the 18 January regarding Mr Kerviel’s unauthorised acts. On the 20 January a total exposure of €50bn was identified and the decision to close out his trading position was communicated to the audit committee and the French Financial Regulators, �Autorite des Marches Financiers’ (AMF). They also made the decision not to publicly disclose his actions until the positions were closed due to the detrimental impact on the market which could potentially affect a number of important stakeholders. These trading positions took four days to close out and Soc Gen calculated a total loss of €4.9bn.

Subsequently, the immediate reaction of investors caused the market price to fall. At closing on the 24 January, Soc Gen share prices decreased to €75.81 down €20 two weeks prior. This news preceded a €2.05bn write-off due to US sub prime market losses.

Although these two events were not the sole instigators for this significant drop in share price, they were the major reasons leaving Soc Gen susceptible to potential takeover. It is worth mentioning that if Soc Gen chose not to close his portfolio as the potential losses would have been far greater due to further falls within the market.

Figure 1- Societe Generale Share Price against CAC 40 (1st Jan 08 – 31st Jan 08) (accessed 10/03/2008)

Within this vulnerable period, President Sarkozy publicly stated his lack of enthusiasm of a foreign takeover (Arnold, M. FT 2008). We feel the government’s protection within the period was greatly appreciated although we believe it was more of a nationalistic statement implying that they would independently resolve and overcome this scandal, typifying the French.

Something to consider would be �what if there was a takeover – French OR foreign?’

French –

The issue surrounding a French takeover is that of competition with the potential acquirers (BNP and Agricole) would lead to unfair domination of the market. This caused Agricole and BNP to assemble a joint venture proposal which consisted of splitting Soc Gen into two separate entities, which would not be in the interests of existing stakeholders.

Foreign –

The French way may not be the best way, but maybe the initiation of a foreign takeover would. Sarkozy and the AMF’s reluctance to this takeover could be that it will identify cracks within the French banking system and possibly trigger further loss of confidence around the already �bruised’ French economy. Within cross country takeovers there is also the issue the expectations of a foreign investor may differ to that of a domestic institution therefore creating a culture clash.

If Soc Gen were to be taken over, it could provide the bank with the much needed unbiased view upon current operations and procedures. A successful takeover could add value by implementing a new, fresh and efficient strategy. An example of this would transfer of existing management’s knowledge and capabilities like the skills possessed by Georges Pauget of Agricole and Baudouin Prot CEO of BNP.

This triggered Soc Gen’s need to repair its damaged balance sheet. They were able to achieve this through a rights issue of €5.5bn underwritten by JP Morgan and Morgan Stanley which consisted of 116 million new shares with a 4:1 share at €47.5, a 38.9 % reduction compared to the market price. (Societe Generale, 11th Feb 08).

Due to the uncertainty of Soc Gen, the offering of this rights issue could have ended with no potential buyers causing the share price to drop far further than anticipated. Soc Gen’s decision to use such reputable underwriters of the rights issue will have played a major part into the attractiveness of the offering, not to mention employing Rothschild and Meryll Lynch to formulate their defence strategies.

We feel that Soc Gen made this financing decision for the benefit of existing shareholders and the positive perception it will give to the market. It allows them to raise the capital required to realign its strategy to compensate for Mr Kerviel’s actions. This includes the front to back revamp of risk and control procedures and the creation of an independent control department. It allows Soc Gen to continue with current lucrative investment plans of expansion within markets such as Central and Eastern Europe as well as Russia therefore supporting the long term view of adding value. In contrast, if Soc Gen were to use debt rather than equity, costs incurred would have been far more risky and costly due to the liquidity crisis and increased borrowing rates subsequent of the volatile capital market.

Above all, the successful implementation of the rights issue would go some way in repairing the damage both Soc Gen and the French financial system have experienced since this exceptional fraud.

The AMF released a document concerning Mr Robert Day and his affiliated trusts which totalled a €148.2m share sell-off over a 9 day period (Jan 9th – 18th) prior to the unveiling of Soc Gen’s losses. Robert Day is an American billionaire financier and non-executive director at Soc Gen. The precision and sincerity of the questions raise considerable doubt into information held by Robert Day and subsequently the Soc Gen board (Lacroix K, 2008).

This event has instigated the full review of not only Soc Gen’s internal controls, but all financial institutions including the French regulatory requirements set by the AMF.

Soc Gen’s aim in shifting strategic power to the back office would definitely benefit the company from a risk perspective, but from a position of making returns required by shareholders, the shift off power could rein in the growth of its main profit generator. For this reason it is unliklely that this strategic shift will become common practice across the market as they will argue it will create greater opportunity costs over its potential bnenefits.

Managements decision to shift power is likely to affect the Groups profit which directly affects the dividends and capital gains receieved by shareholders. In minimising the opportunity cost arising from this change you will ensure that the objectives of the shareholders are aligned with that of the directors minimising the agency problem. Therefore a balanced approach should be considered when implementing this change.

The feasibility of standardising systems must be investigated by Soc Gen as this proved to aid Kerviel’s deception of colleagues management and systems. The problem surrounding the potential upgrading of systems like many other risk and control procedures are the extremely high costs surrounding implementation such as initial setup and maintenance costs. A debate therefore arises in which the question is asked…. �Is it worth it? Do the benefits out way the costs?

Mr Kerviel’s extensive knowledge of control systems were fully appreciated by Soc Gen and his colleagues, as Brady has identified below;

“The organisation should be watching the people with working knowledge of the systems and not the systems themselves – such as Jerome Kerviel and Nick Leeson, who were familiar with back office setup and not the systems themselves (Observer 10 Feb – Chris Brady)

Soc Gen should have recognised from past events that it is far more likely for an individual with extensive knowledge of back and middle office operations to successfully outmanoeuvre the controls in place.

Does this mean that risk management systems should have greater emphasis on the monitoring of individual employees of who have experience of back and middle office operations?

Soc Gen recognise the fact that fraudulent activities are more likely to be carried out by someone with working knowledge of the processes front to back and have learnt this in a brutal way. They are now planning on installing an autonomous internal control unit that is independent from the process flow from front to back. This should capture many techniques used within casino controls with the aim of capturing unauthorised activities whilst they are occurring rather than in the aftermath and effectively when it is too late.

On the flipside if Kerviel had achieved profits of €4.9bn euros, would this have proved a situation that was more difficult to deal with in the eyes of Soc Gen. They would still have to pursue court proceeding and dismiss Kerviel for actions that actually created profits in line with their projected yearly profit. This directly affects the amount of remuneration contributable to management and directors. Due to the unauthorised actions resulting in the excessive profit it would not be in line with corporate governance to benefit from such an activity. Again, this raises the agency debate.

We feel that for the integrity of the banking system it was important that this incident harmed rather than benefited Soc Gen. This Soc Gen affair identifies how disastrous rogue trading can be to a greater extent than ever experienced before. Finally this should provide all financial institutions worldwide with the impetus in investing in top notch risk management tools and controls.

If financial institutions do not learn from this incident, you may ask how much money needs to be lost in order to realise the importance of managing risk?

The current approach taken by large institutions do not seem to be providing sufficient controls within their systems. It is time for the AMF to regulate and implement a standardised risk control system. Opposition could feel that it is the banks responsibility to manage and regulate risk as they are the group directly effected but as we have identified this is not the case as there is a number of stakeholders negatively affected by this event, none more so than the French Government and the AMF.

The AMF and government have received stark reviews since this event has been brought to light. By implementing a solid universal risk control system across the country could minimise the likelihood of such an event reoccurring. Advocates therefore believe that by allowing the AMF to construct and impose strict control systems may be the only feasible way of monitoring such activities consistently across all institutions.

Will this instigate the end of rogue trading?

If not, will the internal controls ever be intelligent enough to discourage such actions?


Anon, 2008, Hard Hitting Lagarde points up lack of control. Financial Times, 4th Feb.

Arnold, M, 2008, Agricole Sets a Clash With BNP over SOC GEN, Finanical Times, Feb 1st 2008

Brady C, 2008, You can beat the system but you can't beat the house, The Observer, 10th Feb

Hughes C, 2008, Traders �should take two-week holiday’, Financial Times, 11th March

Lacroix K, 2008, French Investors Hit Soc Gen with Subprime-Related Lawsuit, D & O Diary, 29th Jan

Macleod C, 2008, The dangers of privileged password management- who’s the next Societe Generale. Feb 08

O’Doherty J, 2008, Custom and practice, or a man with a lot to prove?, Financial Times, 1st Feb.

Societe Generale, 2008, 5.5bn Euro rights issue, 11th Feb. (accessed 10/03/2008)

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