According to a report in today’s UK Guardian, the infamous rogue trader from Societe Generale will stand trial next year to face criminal charges associated with his bad bets.  Jerome Kerviel almost brought down one of the largest financial institutions in the world by conducting a series of trades that led to losses of over $7 billion.  He argues that his actions were not criminal because the bank knew about and encouraged his trading activity until the losses began to mount.  Here is what the Guardian reports about the ongoing investigations.

The independent investigations and the bank’s own internal inquiries into the scandal have found that its managers and control systems failed to operate properly and ignored warnings. A report by PricewaterhouseCoopers blamed the “culture” at the trading desk, describing it as “overheated”. France’s central bank has fined SocGen €4m for “serious shortcomings” in its internal controls that led to the trading losses. Kerviel’s legal team is trying to go further and prove that the bank knew what was actually happening.

Employed at the bank since 2000, Kerviel worked his way up from a desk that monitors traders to a job on the futures desk, where he invested the bank’s money by making huge bets on the future direction of European stock exchange prices. He is accused of causing five times the financial damage inflicted by Nick Leeson, the rogue trader who sparked the collapse of Barings Bank in 1995 with losses of £800m.

At the very least, the bank lacked the controls necessary to prohibit unauthorized trading activity as well as limit authorized trading activity.  As financial institutions and the trading operations they support become more complex, opportunities for fraud and abuse will continue to increase.  Investments in controls and monitoring technology are crucial to prevent future calamities such as this.

An article published in the current issue of Bank Systems & Technology discussed the weak links in the risk management infrastructures of some of the larger financial institutions during last year’s economic meltdown.  It seems that many institutions had to rely on highly manual, time consuming processes to understand their full risk exposures. Here is their view.

Weaknesses in the infrastructure often limited banks to identifying and aggregating exposures across the bank. A fragmented risk architecture dispersed over a multitude of systems made the reconciliation of the relevant data a time-consuming exercise, which was at best semi-automated, but more often a manual process. This led to banks needing far too long to aggregate their exposures and other relevant accounting and risk figures on a firmwide level. In the bankruptcy case of Lehman Brothers, for example, it was reported that it took some banks more than three weeks to determine their overall exposure to Lehman.

An inflexible risk environment within the banks rendered them incapable of reacting to sudden changes driven by external and internal circumstances—for example, the ability to perform ad hoc stress tests to assess the impact of new stress scenarios designed to address a rapidly changing environment.

In short, the interlinkage among risk types was not captured. The recent crisis has exposed the strong dependency among credit risk, market liquidity and funding liquidity pressures. Banks need to move away from silo-based risk management to achieve a more integrated and connected way of managing risk.

An integrated approach is not only required, it is also the most cost-effective solution in times like these.  Wheelhouse Advisors provides services to help companies build an integrated risk management program.  Visit www.WheelhouseAdvisors.com to learn more.

In a HedgeWeek special report this month, particular attention is given to the topic of managing hedge fund risk.  One article describes the failings of hedge funds over the past year to be attributable to poor operational risk management practices.  Here is an excerpt from the article referencing Moody’s Investors Service’s view.

According to Moody’s, a significant portion of losses suffered by hedge funds last year probably reflects deficiencies in operational management and control.  ”Losses that are disproportionately large in the context of the fund’s stated investment strategy may indicate inherent flaws in the firm’s approach to risk control that are not apparent until the market stresses become unexpectedly severe.  Alternatively, such losses may indicate an opportunistic departure from the investment strategy or portfolio guidelines described in the fund’s offering memorandums or other representations made to investors.  In Moody’s view, both scenarios indicate operational deficiencies.

Operational deficiencies can have tremendous impact at the worst possible time.  It is always better to know your weaknesses ahead of market catastrophes so you can remedy them to weather the inevitable storm. Wheelhouse Advisors can help your company or fund identify and correct the deficiencies in a cost-effective way. To learn more, visit us at www.WheelhouseAdvisors.com.

Yesterday, the U.S. House Committee on Financial Services conducted a preliminary hearing into the investigation of regulatory failure associated with the $50 billion Madoff Hedge Fund fraud.  Among those testifying was Leon M. Metzger, a Yale University professor and expert on hedge fund management.  His commentary included the following:

I wish to stress two things: first, the need for top-notch internal controls and second, that operational risk is the great unspoken danger.   A 2003 study of 100 hedge fund failures over a 20 year period concluded that 50 percent of hedge funds had failed due to operational risk…  When I was interviewed in August 2004 about teaching a hedge funds course at the Yale School of Management, I said that I wanted to emphasize good operational controls, which investors tend to overlook, and are essential to the success of an investment.  I was offered the job, and the importance of those controls is what I stress whenever and wherever I teach.  

Many risk experts fail to recognize the importance of strong internal controls, but they are (to use a football analogy) the “blocking and tackling” of risk management.  Without a solid internal control framework, any hedge fund, financial institution or corporation is likely to suffer a similar demise.  Wheelhouse Advisors can provide a no-cost diagnostic review of your internal control structure.  Visit www.WheelhouseAdvisors.com to learn more.

As the financial crisis continues to unfold, one area of risk management that is gaining an increasing amount of attention is operational risk.  Operational risk is typically defined as the risk of loss resulting from inadequate or failed internal processes, people, technology or from external events.  Earlier this year, the massive trading losses at Société Générale resulting from the activities of a rogue trader exemplified the need for stronger operational risk management practices.  Just last week, the Financial Times reported that,

“…..some of the world’s biggest investment banks, including Goldman Sachs, Morgan Stanley and Citigroup, issued a report criticising risk management at their own institutions and urging “serious and sustained investment” in better people and technology.”

Greater investment is needed to get ahead of the operational risk curve before the next rogue trader comes along.  What do you think?  Please share your comments below.