Risk & Economy » Regulation » Gallic shrug

Société Générale suffers a e4.9bn loss in the biggest rogue trading scandal
in banking history and, in response, the French government declares it is
looking into tightening banking regulations.

The finance ministry is calling for a clearer division of roles between
regulators and the government in situations in which the stability of the
financial system could be at risk.

France is also recommending more stringent penalties for fraud and is calling
for early talks with its trading partners on the fall-out from the scandal. The
call for more stringent standards for regulating operational risk refers to the
vulnerability of banks to the failure of their internal systems, rogue behaviour
by staff and unforeseen events.

“That’s like re-arranging the deck chairs on the Titanic,” says one analyst
at a UK investment bank. “I fail to see how tougher regulations can stop these
traders running their own fiefdoms. The practice has come to the point where I
once saw the head of forex at a major European bank trading on his mobile phone
on a ski lift in Chamonix.”

Blame game

France’s opposition party threw every ounce of firepower it could muster into
this golden opportunity to hit the government. The ruling conservatives,
therefore, lost no time in pinning the blame on Société Générale’s appalling
lapse of risk control.

The finance ministry also absolved the government by saying the bank took too
long to report the suspicious activity to the regulatory authorities. “Certain
mechanisms of internal controls at Société Générale did not function, and those
that functioned were not always followed by appropriate modifications,” said
finance minister Christine Lagarde. What Lagarde, the government and Société
Générale itself failed to acknowledge was that high-flying traders have become a
law unto themselves.

Norman Bernard, director of banking consultancy First Consulting, agrees,
saying that traders have gained a highly dangerous level of autonomy. “Will
anything be achieved by tightening up banking regulations?” asked Bernard. “The
answer is simple and it was given by the trader Jérôme Kerviel himself, when he
said he hadn’t taken a holiday for a year and never handed over his trading
position to any of his colleagues. You can pass laws for as long as you like.
What you need is a management team that gives a damn about managing risk and
assigns a higher priority to this than to bonuses.”

There were gasps of disbelief from some when Kerviel admitted that he had
failed to go on holiday for 12 months, an obligation that is written into every
contract of employment as well as every manual issued by consultants. Standard
work practice at any global investment bank dictates that somebody intercepts a
trader’s emails and telephone calls when they are away.

In the case of Société Générale, nobody picked up on what Kerviel was doing
or who his counter-parties were. Had he been on holiday, one or more of his
colleagues would have almost certainly seen those vital bits of paper. This is a
natural and vital control in any internal risk management system. Hence there is
nothing to be gained by tightening up rules that are being ignored.

The cold fact is that, just like the Nick Leeson case at Barings in 1995,
whose £700m trading loss seems a piffling matter compared with the Société
Générale scandal (though with more catastrophic results as far as the smaller
British bank was concerned), as long as the trader was making big money for his
employers, nobody asked questions.

“The killer was allowing a trader access to a Swift system,” says Bernard,
referring to the secure, interbank messaging service. “He became too powerful,
nobody demanded explanations and Kerviel himself said that nobody challenged his
unit. This is not about tougher legislation. Making sure that the trader takes
holidays and doesn’t have their own Swift machine is a behavioural more than a
regulatory issue.”

Meanwhile, Société Générale has launched a e5.5bn rights issue to plug holes
in its balance sheet. At the capital raising presentation, the bank said it was
taking internal measures to deal with short and longer term tightening of
controls. This will involve a reconciliation of certain types of settlement
procedures and links between the back, middle and front offices. Société
Générale also intends to ensure that employees take their statutory holidays.

“These measures seem simplistic,” says Janine Dow, a senior director with
Fitch Ratings in Paris. “However, they’ve appointed a team of external fraud
specialists, a step which we favour. Operational risk is the most difficult one
to detect. Many banks suffer from minor problems of this nature that generally
cost very little money. But the ones at the tail end of the distribution curve
are far out and hard to capture and so many of these fraud-related problems are
linked to the dealing room.” Dow says that banks with large trading activities
will probably be re-visiting their risk management controls.

They should also be thanking their lucky stars it happened to Société
Générale first.