RISK MANAGEMENT : THE PRESENT INDUSTRY NORM

The $7.1 billion rogue-trading scandal at French banking giant Societe Generale reported on the beginning of this year (Jan 21, 2008) shows how risk management in the industry became during the recent market boom.

“Over the past few years, risk management has been an oxymoron. Banks haven't been doing it," said Larry White, professor of economics at New York University's Leonard N. Stern School of Business. "They thought that all the extra return they were getting was because they were the smartest, not because they were taking a lot of risk and were just being lucky."

“That's what good management is about," he added.

SocGen stunned financial markets when it revealed that a single trader, Jerome Kerviel, lost $7.1 billion of the bank's money in one of the largest-ever frauds by a rogue employee. The company said the Paris-based trader used his knowledge of the bank's control procedures "to conceal these positions through a scheme of elaborate fictitious transactions."

Jerome Kerviel, the 31-year-old Paris-based trader who worked on Soc Gen’s European equities derivatives desk, was less than seven years into the job. Rather his annual salary of $140,000 was pretty routine for middling traders. Most puzzling of all, he does not seem to done it for personal gain. Yet his actions cost the bank $7 billion and forced it into an emergency $7.8 billion cash call on shareholders.

It was explained by the bank that Mr. Kerviel’s role on the trading desk was that of an arbitrageur, which meant that he was entrusted to purchase one portfolio of stock index futures and at the same time sell a similar mix of index futures, but with a slightly different value. The object of arbitrage is to try to make profits from these differences in value. Because the value gaps between similar financial instruments are usually very small and temporary, this type of activity typically involves trading in very high total nominal amounts. Mr. Kerviel’s fraud, according to the bank, consisted of placing sizable, real purchases in one portfolio but creating fictitious sales transactions in the second, offsetting portfolio. This gave the impression to risk managers that the risks in the first portfolio were hedged, when in fact they were not. As a result, the bank wound up exposed to huge one-way bets, or long positions. Instead of hedging, which was his job, Mr. Kerviel was effectively speculating with the bank’s money.

Each time one of Mr. Kerviel’s trades was questioned, he would describe it as a “mistake” and cancel the trade, Mr. Mustier said. “But in fact, he then replaced that trade with another transaction using a different instrument” to avoid detection, he said. Mr. Mustier also said that Mr. Kerviel’s fake trades did not fall into an identifiable pattern.

Soc Gen seems to have weathered the storm better, despite the significantly larger amount involved ($7 billion as against $1.4 billion in Leeson’s case). That’s partly because of more deft handling of the situation (it discovered the problem over the weekend but waited to unwind its position before it went public) and partly because its shareholders rode to the rescue. If shareholders had not obliged and news of the bank’s problems had leaked out, it could well have triggered a run on the bank and a payments crisis, exposing entire banking system to huge risk. Ironically, there are fewer things modern banks take more seriously than risk management. On paper that is. And in the complex world of financial engineering where no one quite understands many transactions, it is easy to pull the wool over everyone’s eyes. The fraud raises a number of questions about modern financial architecture — from regulation to incentives to the nature of the work that encourages people to work as lone wolves rather than in teams.

There is no substitute for personal integrity. We’ve known that all along. Yet each time there is a major fraud, as at France’s second largest bank, the 140-year old Societe Generale, we look for reasons and then for ways to try and prevent the next fraud. Yes, banking is about taking risks. Typically banks take short-term deposits that are repayable on demand and lend longer term. Thus there is a maturity mismatch in that when the depositor demands his money back, the bank must be in a position to repay it even though it may have lent the money. Banking in its simplest form is about managing this risk. Over the years however, banks have begun to take on more and more risks. And since higher risks usually mean higher rewards, there is a built-in incentive to do so. This has been aggravated by a compensation structure that directly rewards those who undertake huge risks like dealers in complex derivative instruments relative to those in the back-office who do the relatively unglamorous job of monitoring. Ideally banks themselves must steer clear of excessive risks. But since that is unlikely to happen — the hunger for more and more profits combined with blind faith where each bank thinks its systems are foolproof rules this out — we need to devise a better way. Till then, the next fraud will never be very far away.

Contributed By:

Arjun Pal

(Knowledge Cell - Globsyn Business School)