Kerviel at last
One of the wisest things David Goodhart, the editor of Prospect, taught me was never to write about hot news: when everything’s bubbling all you can do is repeat what everyone else is saying, and usually that turns out to be wrong. He’s quite right and that is my reason for, until now, laying off the SocGen trader Jérôme Kerviel. But now at last I’ve found something which adds depth to the story.
I know next to nothing about banking, and even less about investment banking - the wonderfully astute Tom Freke of LoanStar refuses to reply to my emails, so I can’t call on his take. Instead I just want to point out a piece of the jigsaw supplied by this week’s Economist. When the story broke my instinct told me that one guy cannot lose that amount of money unperceived and that Kerviel couldn’t be the terrible lone fraudster headline-writers and his boss were far too readily calling him. When the examining magistrates (including the excellent Renaud Van Ruymbeke) decided that Kerviel should not be charged for fraud but for the lesser offences of abuse of trust, breaching computer security and falsifying documents, that seemed to me a major step in the right direction. Now the Economist adds to the malaise by telling us very simply about the internal cops working for Société Générale who should have cottoned on to Kerviel long ago: “the bank’s annual report for 2006 devotes 26 reassuring pages to its risk-management practices; more than 2,000 staff worked in the function that year and more bodies were added in 2007. Yet none of them stopped Jérôme Kerviel.” 2,000 people to watch how many traders? One longs to know what they were doing, and did they find and prevent lots of other abuses which are not publicised? To justify that many well-paid technicians they must have. But they either didn’t find or they colluded with M. Kerviel. Nor are the French blind about finance: as the Economist points out, “France’s financiers have helped develop the very markets the political elite profess to deplore. French financial innovation is considered world-class. In the 1980’s the Société Genérale was a pioneer in the development of sophisticated equity derivatives, based on the complex mathematics in which the elite French education excels. It drew on a steady stream of brainy graduates from the grandes écoles….”
The common cry now from hacks and M. Sarkozy is regulation – everything must be regulated. But it sounds as if it already is: if 2,000 specially trained in-house controllers working round the clock can’t find a Kerviel, how many does it take? Ah, but this one was exceptionally bright! “When challenged,” said Jean-Pierre Mustier, head of SocGen’s investment-banking, “he was clever enough to say that he’d made a mistake.” Wow! Now that really is clever! No wonder those 2,000 brainy controllers never suspected anything!
February 7th, 2008 at 12:02 am
I’ve also held off commenting for the same reasons you described. I do know a bit about banking and trading (having run trading businesses at a large investment bank) and perhaps can add some insight. I won’t go so far as to guess at the sequence of events that resulted in SocGen’s loss - I simply don’t have enough information to make an intelligent addition - however I can speculate as to why a typical large bank’s risk management department might fail more generally. In my experience, the risk management functions of large banks have a significant bias towards analysing, opining upon (second guessing) and generally ‘backseat’ trading the ‘declared’ risk of the bank. That is to say that the focus is on monitoring and interpreting the risk spit out by the system. Insofar as the “system” is concerned, the focus is on designing, implementing and auditing the financial and mathematical models used to produce the risk numbers - in particular the VaR (Value at risk.) Notwithstanding the enormous limitations of VaR as a risk measurement (see Taleb’s Black Swans for an eloquent and accurate summary of the intrinsic flaw of VaR as a risk tool,) once these measurements are ‘hard coded’ into the systems, they numbers are seen as robust and risk management focuses on compliance vs established limits and policies and too often sees their role as being a devil’s advocate to the traders and management as to the appropriateness and ‘rightness’ of the risk. So when the problem arises because the inputs are wrong (fraudulent) there is a much higher chance of it being ‘missed.’ I suspect further that when the underlying risk is simple (as seems to be the case with SG - ie long listed futures) ironically the chances of this being overlooked is higher: it’s not sexy from a risk management point of view. If he had been mucking about with long dated barrier options, even with fraudulent inputs, falsification, etc. I believe there would have been a higher chance of risk management paying attention and digging deeper, earlier. Alot has been written about how SG - this super smart equity derivatives house - has been bitten by its own cleverness but actually, their losses were not due to derivatives magic gone wrong - Kerviel was just long shares - there wasn’t anything wrong with models, volatility assumptions, etc.
I also think the government’s response is misguided. The best way to protect against a repeat (one can’t insure against this ever happenning again no matter how many volumes of regulations are written imo) is to let the market work - ie if SocGen is taken over as a result of its weakened position, that would be the strongest possible signal for other banks to do their best adapt their procedures as needed to ensure this can’t happen. Ironically by seeming to protect SG from these market forces, Sarkozy’s government is implicitly underwriting other (French) banks risk management. Ironically, the best policy is aptly described by a great French expression…”pour encourager les autres…”
February 7th, 2008 at 4:46 pm
Quickly on your second paragraph (I find the first one very helpful and good to think about), I agree absolutely - but that is the classic difference between the market and the state. I find it extraordinary that the statists cannot see that the best way to improve things is by making mistakes and taking the consequences. Being molly-coddled never got anyone anywhere. But to my great sadness I can see that France simply is not ready for that. More on that soon….