The Societe Generale scandal

Written by YRK Reddy | Updated: Feb 2 2008, 07:21am hrs
The recently discovered fraud at Socit Gnrale gives a feeling of dj vu. Will the investigations and conclusions also follow the same old pattern till memories fade and the episode repeats itself The failure of Barings has been a case study of poor internal controls, laid-back supervision, tolerance of transgressions that yield profits, and overall laxity with risk management. In the case of Socit Gnrale, too, Jrme Kerviel has revealed how easy it is to play risky games out in front and wire up the back-end suitably. The estimated loss of over $7.1 billion is the biggest so far in banking history, and is over five times that caused by Nick Leeson of Baringsof course, Kerviels lawyers have claimed that the charges have been put forth only to mask or divert attention from other losses incurred by the bank.

The lessons being drawn may soon include that a person who worked long years in the back office should not be posted in the front officeas the 31-year-old Kerviel had learnt the ropes of back office controls before moving to the trading desk, even though some analysts point out the ineffectiveness of such a separation in markets for derivatives. Another conclusion possibly is that greater the returns in a segment, the lighter tends to be the supervision. The derivatives and forward contracts markets had reportedly yielded returns of over 40% more than that by the banks retail business. A Wild West culture seems to prevail in such high-strung trading zones that encourages adventurism, cosmetic management of problems and even outright fraud.

There are three other notable lessons. The first is for companies that house risky behaviour. Employees hired for sensitive jobs are not tested to check patterns of behaviour under extreme conditions that inspire gambles that verge on fraud. This is what transforms a Jrme Kerviel into a stunt motorcyclist, an Evel Kneivel, who risks his life amid loud applause. It is amazing how even otherwise intelligent people demonstrate such poor judgment in pursuits of extreme risk.

Recruiters must now use advanced assessment centres and intensive tests that can detect worrisome behaviour patterns, and not be satisfied with box-ticking exercises that let candidates show what they want to show. In addition, better research is needed to track behavioural patterns and their outcomes, combining technology and psychology.

The second big lesson is for financial economists, especially those who believe in the efficiency of markets. These frauds time and again show that there is much information inefficiency that makes space for transgressions. This inefficiency is heightened by the use of advanced financial products, ironically devised to do just the opposite, the riddled prices of which are often justified in terms of legitimate arbitrage play. The question, however, is whether the arbitrage is of rates, information gaps or ignorance.

Policymakers and the judiciary should do some thinking as well. The world of finance seems to attract the brightest professionals, and is a victim of fraud all too frequently. Is it greed Or is it also because the incentives of profit outweigh by multiples the disincentives of punishment Kerviel has been swiftly released from custody, but Haneef Mohammed was jailed for weeks on mere suspicion, and Paris Hilton spent several days in the slammer for driving under the influence of alcohol. Nick Leeson served a prison term, and is back to normal life, while fishermen straying into foreign waters have to languish in jails for longer.

Punishment standards for big-money frauds seem unusually easy the world over. Is it because the suckers here are mostly faceless Financial professionals are often highly competent and humane individuals. Yet, theyre often also okay with insider trading, false pricing and accounting skullduggery. Is it the anonymity of the losers Cheating those whore unseen appears to be dangerously acceptable. But then, there may not any lessons learnt at all: to paraphrase a blogger, even as Kerviel may be Nicked, none may learn a Leeson.