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Case study: Societe Generale 2008

Abstract

Société Générale’s financial disaster was owed to inappropriate use of derivatives when junior trader’s unauthorized trading led to an ultimate loss of €4.9 bn. The causes, market reactions and consequences are described, with supporting evidence like Finance Minister’s reaction, briefly touching upon the role of different market participants. This case is a typical example of history repeating again, hence SocGen’s shortcomings are discussed in length through the seven lessons realized during case analysis. These lessons highlight the banks’ fault in terms of daily reporting, financial risk limit, supervision of trades, improper incentive management and ineffective risk management

Table of contents

  1. Introduction
  2. Body
    1. Consequence
    2. Market reaction
    3. Lessons
  3. Conclusion
  4. Reference List

Introduction


source : Wikipedia

Société Générale is a French multinational investment bank company, also providing financial services and retail service. On 18th January 2008, the establishment faced losses attributing to a net estimate of €4.9 billion ($7 billion). These losses were detected by Basel II mechanism when banking system’s weighted capital needed  an extra €3 billion for compliance. This attracted the internal auditors who discovered on 19th January that the unauthorized trading traced back to Mr. Jerome Kerviel. This was followed by closing out those trade’s positions.

At the same time European stock market prices fell sharply due to the subprime mortgage crises in US. Here, the main cause of derivative disaster was the unauthorized use of the European stock market indices and futures contract for betting at inappropriately large positions. The report aims at consequences and market reaction and major lessons learnt through case analysis for better preparedness in future case scenarios.

As a consequence stock price of the bank fell to generate a loss of six billion euros (20% of bank’s equity). The stock prices fell 25% from February to mid-April of 2008, while bank’s rating lowered from ‘AA to AA-’ , giving it a negative outlook. However SocGen was able to secure issue rights underwritten by Morgan Stanley and JPMorgan Chase, where shares were sold by SocGen at a discount of 30% to 40%(Walker. R, 2013). Additionally, no takeover bids were realised as competitors like Duetsche Bank, Credit Agricole and UniCredit were preoccupied with the mortgage crises. Meanwhile, Kerviel was officially charged on the basis of illegal access to computers and abuse of confidence on 28th January and convicted for imprisonment of three years with a fine of $5.5 bn, which was eliminated in the later years.

Eventually, Daniel Bouton gave up his title of CEO. Moreover, the information on financial crisis to board members was delayed. Certainly, shareholders were affected as SG’s major proportion of earnings were generated by derivative equity products. As for the government, finance minister imposed a fine of 4 million euros along with other regulations as a reprimanding measure. However, SG dealt with the public using acceptable crisis communication management(Pichet, 2010). In addition, financial analysts suggested unauthorized trading must have been covered under the high volume low risk trades conducted by Kerviel (Financial Times, 2008).

There are many lessons to be taken from Société General’s mishap.

Firstly, Daily reporting of capital gain or loss

experienced must be practiced by companies, where variance analysis should be performed to ensure that the valuation procedures underlying the reports are accurate. This is because daily reporting could help trailing cash flows. For instance, there were large trading positions made by SocGen’s rogue trader, Mr. Kerviel, whose margin CFs made up 25 % of SocGen’s total cash flow movement (increased to an overall 40% by late November, refer fig. 1). Here, daily reimbursement to each clearing house should have been practiced by the back office to keep in check of CF movement besides daily reporting.

Additionally, the reinforcement of daily reporting was also recommended in Finance minister’s report (Reuter, 2008).

Secondly, financial risk limits to be implemented

strictly in banking and finance related establishments. In case of Société Générale, Mr Kerviel’s open trading limit of 125 million euros only exceeded by a little in 2006, however reached a net position of € 30 bn by July 2007. This is because once Kerviel speculated taking financial risks, his trading positions only increased as more profits were accompanied by further large losses. This certainly implies that the culture of not taking risks seriously is short-sighted.

3. Regular monitoring of traders

Companies must keep their traders under regular check in terms of sizes of position they take else the derivative traders switch positions as in case of Société Générale. Kerviel was expected to make riskless profits as a junior arbitrage trader but switched to being a speculator in early 2005 and fake trading increased in size and frequency with less monitoring.

4. Do not mix up front, mid and back office

Moreover, such effective fraudulent trades were performed using intimate knowledge on computer based bookkeeping and tracking systems from previous work experience in the back and middle office. Thereby, bringing forth the lesson that separating the front, mid and back office is crucial. Evidently Société Générale’s operation didn’t follow well.

5. Proper management of incentives.

In July 2007, Kerviel faked a reporting of reasonable 43 million euros but in reality realized 1.4 billion euros from fictious stock index futures and covered them through unrealized losses on fake forwards worth 1.357 billion euros(refer fig. 2 and 3). Furthermore,  requested for a bonus of 600,000 euros for this. Clearly, his performance was incentive based. In an investigation later, Kerviel revealed that he wanted to offset the 1.4 billion profit made to surprise the bank authorities later(Jacque, L., 2015).

Thus reward/bonus method of SocGen should have focussed on long term basis to avoid traders from resorting to short sighted trades that have a disastrous impact in the long run.

6. Risk management should never be ignored.

Having said that, Finance Minister stated during government press conference that SG’s loss arose from poor supervision and risk management. Additionally,  report prepared by PricewaterhouseCoopers (PwC) mentioned a continuous breakdown in the bank’s computer information systems due to lack of supervision which effected the management control (Baker, 2017). In continuation, another key lesson is the importance of managing internal controls. Indeed Kerviel’s derivative disaster was majorly credited to the multiple dysfunctions and lack of responsibility by internal control systems. There was no response on the managerial level for endless red flags given on many occasions. In particular the purchase of 6000 DAX futures contracts, worth 1 billion euros on 19th October 2007, failed to grab attention by senior management (Baker, 2017). Another instance where Kerviel’s direct supervisor’s position was vacated for 3 months, gave him time to access the control system’s tolerance of unethical trading limits(refer fig. 4).

Fig 4 Date of Kerviel’s manager
departure(23/01/07)

Conclusion

In conclusion, Société Générale’s financial disaster is owed to inapt use of derivatives as a consequence of which the bank faced major losses as large portions of income relied on derivative equity products. Jerome Kerviel’s switching positions from a junior arbitrage trader to speculation ultimately costed an expensive loss of €4.9 billion. The backwash of the derivative blunder witnessed 20 per cent decline in its stock price, sold shares at 30 to 40 percent discount and its bond ratings fell, to name a few. Hence seven major lessons are considered for greater vigilance in future financial corporate scenario.

Reference List

Baker, Richard, C., Cohanier, Bruno, Leo, & Nancy, J. (2017). Breakdowns in internal controls in bank trading information systems: The case of the fraud at Société Générale. International Journal of Accounting Information Systems, 26. Published. https://doi.org/10.1016/j.accinf.2017.06.002

CNN. (2008, January 29). Report: Trader had drawn red flags. Retrieved from http://edition.cnn.com/2008/WORLD/europe/01/29/rogue.trader/

Computer Fraud & Security. (2008). Société Générale releases fraud investigation findings. Retrieved from https://www.sciencedirect.com/science/article/pii/S1361372308701064?via%3Dihub

Connor, D. (2008, January 31). How to lose $7.2bn with just a few Basic skills. Retrieved from https://www.theregister.com/2008/01/31/kerviel/

Hull, J. (2017).Chapter 36: Derivative Mishaps and What We Can Learn From Them.[E-book]. In Options, futures, and other derivatives(global edition) (9th ed., pp. 828–861). Retrieved from https://ebookcentral.proquest.com/lib/monash/reader.action?docID=5187580&ppg=829

Jacque, L. (2015). Chapter 11: SOCIÉTÉ GÉNÉRALE [E-book]. In Global Derivative Debacles (2 Edition, pp. 179–196). https://doi.org/10.1142/9789814663267_0011

Jacque, L. (2015). Chapter 18: From Theory To Malpractice: Lessons Learned [E-book]. In Global Derivative Debacles (2nd ed., pp. 309–325). Retrieved from https://doi.org/10.1142/9789814663267_0018

Les Echos. (2008, February 4). Société Générale : le rapport Lagarde. Retrieved from https://www.lesechos.fr/2008/02/societe-generale-le-rapport-lagarde-507380

Pichet, E. & ResearchGate. (2008). What Governance Lessons Should be Learnt from the Société Générale. Kerviel Affair, 3(7282), 117–138. Retrieved from https://www.researchgate.net/publication/228308998_What_Governance_Lessons_Should_be_Learnt_from_the_Societe_Generale%27s_Kerviel_Affair

Reuters. (2008, February 4). French government statement on SocGen report. U.S. Retrieved from https://www.reuters.com

Sayer, P. (2008, April 17). What You Can Learn about Risk Management from Societe Generale. CIO. Retrieved from https://www.cio.com

SocGen postmortem. (2008, January 25). Retrieved from https://www.ft.com/content/13e0c5b0-cb28-11dc-97ff-000077b07658

Walker, R. (2013). Scandal at Société Générale: Rogue Trader or Willing Accomplice? In SAGE Business Cases. Published. https://doi.org/10.4135/9781473972384

About the author

Sarah Singh, Bachelor of Commerce and Finance,

3rd year student, Monash University.

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