Another Example of the Value of Risk Management

It seems that some financial institutions have not fully learned the lessons from past rogue trading incidents such as the ones that occurred at Societe Generale and Barings. Officials at UBS announced today that they are facing massive losses at the hands of a lone trader. Here’s what BBC reported this morning.

Police in London have arrested a 31-year-old man in connection with allegations of unauthorised trading which has cost Swiss banking group UBS an estimated $2bn (£1.3bn). Kweku Adoboli, believed to work in the European equities division, was detained in the early hours of Thursday and remains in custody. UBS shares fell 8% after it announced it was investigating rogue trades. ZKB trading analyst Claude Zehnder said the news would damage confidence in UBS. “They obviously have a problem with risk management.”

This is yet another example of the value of having a strong risk and control program. While it is difficult to control external events, companies can certainly implement proper internal controls to protect from massive losses such as this one.

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Who Is Really to Blame?

Yesterday, the infamous Jerome Kerviel was sentenced to three years in prison and ordered to repay the estimated €4.9 billion that the French financial institution Société Générale lost as a result of his failed derivative trades. What is surprising to many who have weighed-in on the verdict is the fact that the sole blame for the massive losses has been placed on the young trader.  Here’s one common view as reported in the New York Times.

“It’s a whitewash,” Bradley D. Simon, a white-collar criminal defense attorney at Simon & Partners in New York who specializes in securities and bank fraud, said of the verdict. “The evidence does not support absolving the bank completely,” he said. “This was a lot larger than Kerviel.”

Société Générale had admitted to management failures and weaknesses in its risk control systems. An internal audit published in May 2008 described Mr. Kerviel’s immediate supervisors as “deficient” and acknowledged that the bank had failed to follow through on at least 74 internal alerts about Mr. Kerviel’s trading activities dating to mid-2006.

While an appeal of the verdict is virtually guaranteed, the larger question remains. How can a situation like this unfortunate one be prevented in the future?  The answer certainly begins with stronger risk and control programs as demonstrated by the numerous weaknesses found at Société Générale.

Did Calamity Jerome Commit a Crime?

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.

Société Générale rogue trader to stand trial next year