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Société Générale claims €4.9bn trader fraud

Thursday, 24 January 2008

The French bank Société Générale claims to have uncovered an exceptional fraud in a sub-section of its market activities.

The group claims that one rogue trader, named by the Financial Times as Jérome Kerviel, a 30-year-old Frenchman who joined SocGen in 2000 and was responsible for plain vanilla futures hedging on European equity market indices, had taken massive fraudulent directional positions in 2007 and 2008 beyond his limited authority.

Aided by his in-depth knowledge of the control procedures resulting from his former employment in the middle-office, he allegedly managed to conceal these positions through a scheme of elaborate fictitious transactions.

Negative impact

SocGen said that was no residual exposure in relation to these positions, which were discovered and investigated on 19 and 20 January 2008. It added that it had decided to close these positions as quick as practicable in the best interest of market integrity and the group’s shareholders.

“Given the combination of the size of the positions and the very unfavourable market conditions encountered, this fraud has a negative impact of €4.9 billion that the group has decided to recognise in its 2007 pre-tax income,” the bank said in a statement.

The trader’s positions have been reviewed and a thorough analysis of his department’s positions confirmed the isolated and exceptional nature of this fraud.

SocGen said that the employee, who has confessed to the fraud, has been suspended and a dismissal procedure had been initiated. It added that the individuals in charge of his supervision would also leave the group.

France's second largest bank said it expects it net income for 2007 to be in the range of €0.6-0.8 billion, including the resulting loss from this fraud and additional US residential mortgage and monoline related write-downs of €2.05 billion in the fourth quarter of 2007.

SocGen will launch a capital increase of €5.5 billion as a result of the alleged fraud and in order to strengthen its capital base.

Error accounts

Others expressed doubts that a single trader would have been able to amass losses on this scale. Ironically, SocGen has just been named Risk magazine's Equity Derivatives House of the Year.

The case echoes that of the former derivatives trader Nick Leeson, whose unsupervised speculative trading caused the collapse of Barings Bank, the United Kingdom's oldest investment bank.

Leeson made unauthorized speculative trades from 1992 that at first made large profits for his employer, which accounted for 10 per cent of Barings' annual income. He earned a bonus of £130,000 on his salary of £50,000.

His luck soon went sour, and he used one of Barings' error accounts - accounts used to correct mistakes made in trading - to hide his losses. Leeson used this account to cover future bad trades.

Management at Barings Bank also allowed Leeson to remain chief trader while being responsible for settling his trades, jobs that are usually done by two different people. This made it much simpler for him to hide his losses from his superiors.

The account's losses exceeded £2 million by the end of 1992, which ballooned to £208 million by the end of 1994.

Risky new investments

The beginning of the end occurred on 16 January 1995, when Leeson placed a short straddle (an options trading strategy) in the Singapore and Tokyo stock exchanges, essentially betting that the Japanese stock market would not move significantly overnight.

The Kobe earthquake hit early in the morning on January 17, however, sending Asian markets and Leeson's investments into a tailspin.

Leeson attempted to recoup his losses by making a series of increasingly risky new investments, this time betting that the Nikkei Stock Average would make a rapid recovery. The recovery failed to materialise and he succeeded only in digging a deeper hole.

Realising the gravity of the situation, Leeson left a note reading "I'm Sorry" and fled on 23 February.

Losses eventually reached £827 million, twice the bank's available trading capital. After a failed bailout attempt, Barings was declared insolvent on 26 February 1995.

Lack of controls

Forensic accountants at PKF warned that City banks and financial institutions need to review their financial controls urgently following the £3.7billion loss at French bank Societe Generale.

PKF partner David Dearman says that the fraud highlights the continuing lack of controls at some major financial institutions.

"The lessons of the Nick Leeson and Barings case in 1995 appear to have been forgotten by some. The scale of this clearly surpasses that fraud and is truly shocking," he adds.

Dearman says that the Leeson case was a clear warning of what can happen if vast amounts of money are placed in the hands of individual traders and effective procedures not put in place for supervising its use. While the full details of how this happened are not yet available, he says that it sounds as if there has been a massive failure of corporate governance and control procedures.

Complacency biggest risk

"There was much soul-searching and review of procedures at financial institutions in the City of London following the revelations at Barings and I know that procedures were tightened up in a number of instances where problems were uncovered," Dearman adds.

He says that the biggest risk is always complacency. It is highly important that once procedures are in place, they are strictly adhered to, monitored and regularly reviewed; staff must understand and be trained in identifying risk; and, where breaches occur, effective disciplinary action should be taken so that the seriousness is brought home.

"I can only trust that the procedures adopted in the City a decade ago are working and being regularly reviewed but there will undoubtedly be some very nervous senior people in the industry today," Dearman says.

He concludes that confidence requires that there are effective checks and balances in place and that they are being audited and lessons learned.

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