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Financial Risk Management: Société Générale case

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In 2008, Societe Generale reported trading losses of $7.1 billion that the firm attributed to unauthorized activity by a junior trader, Jerome Kerviel. It damaged Societe Generale’s reputation and forced it to raise large amount of new capital. Kerviel took very large unauthorized positions in equities and exchange- traded futures, concealed through fictitious forward starting transactions that offset the risk and P/L of his true trades. He relied on his knowledge of when control personnel would seek confirmation of a forward – dated trade, and cancelled the trade prior to the date of confirmation would be sought. Kerviel had previously worked in the middle office of the firm, which may have provided him with particular insight into the actions of control personnel.

A number of factors led to Kerviel’s unauthorized positions to stay undetected. Such as:

  1. System Limitations: There was no procedure in place in the firm that required control functions to confirm information entered for a trade that had been canceled at any point nor was there a system in place for red- flagging an unusual level of trade cancellations.
  2. Weak Supervision: Kerviel’s immediate manager resigned in January 2007 and until the manager was replaced, his positions were validated by his desk’s senior trader. Supervision from new manager remained to be weak.
  3. Colluding Trading Assistant: Kerviel’s trading assistant reported to the control function and was the primary contact for them. He accepted his directions without questioning.
  4. Vacation Policy: The normal precaution of forcing a trader to take two consecutive weeks of vacation in a year, during which time his positions would be managed by another trader, was not followed. If it was, it would easily have caused the collapse of a scheme based on constant rolling forward of fraudulent trading entries
  5. Gross positions: There were no limits or other monitoring of Kerviel’s gross positions, only his net positions were monitored. Monitoring of gross positions would have revealed the abnormally large size of his activities and might have raised a suspicions. Kerviel’s unusually high amount of brokerage commission related to his high level of gross positions could also have provided a warning sign.
  6. Cash & Collateral: The use of fictitious transactions to conceal positions often created positions of unusual size in cash and requires collateral (since fictitious trades do not generate any cash or collateral movements, and hence do not balance the cash and collateral needs of the real trades).
  7. Profits and Losses: Kerviel was reporting trading gains in excess of levels his authorized positions taken could have accounted for, and this should have given the his management and control functions a warning sign to investigate closely the source of his earnings, but these signs were not heeded to.

Finally, one of Kerviel’s fictitious trades was identified as fabricated by control personnel as part of routine monitoring of positions, leading to a thorough investigation. Kerviel’s attempts to deflect the inquiry by forging confirmations proved fruitless and eventually led to Kerviel’s downfall in January 2008.

From the above case we learn the following points:

  1. Tighter controls: Control team should tighten the procedures that may lead to detection of fictitious trades.
  2. Trade audits: Risk infrastructure should monitor patterns of trade cancellations and flag any trader who appears to be using an unusually high number of cancellations. Cancellations should be checked to make sure they represent real trade.
  3. Supervision: Control personnel should be aware of situations in which traders are being supervised by temporary or new managers.
  4. Trading Assistants: Trading assistants are often under intense pressure from the traders with whom they work closely, since their job performance ratings and future career paths often depend on the trade. It convinces a trading assistant to see things from the trader’s viewpoint.
  5. Vacation policy: Rules for mandatory time away from work should be enforced.
  6. Gross positions: Gross positions must be monitored and highlighted in control reports. Unusually high ratios of gross to net positions are a warning sign of potentially inadequately measured basis risk as well as a possible flag for unauthorized activities.
  7. Cash and Collateral: Cash and collateral requirements should be monitored down to the individual trader level.
  8. Profit and Loss: Any patterns of P&L that are unusual (relative to expectations) need to be identified and investigated both management and the control functions. Comparisons should be made to historical experience, to budgeted targets, and to the performance of traders with similar levels of authority.

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