CHAPTER23

Control Complacency Rogue Trading at Societe Generale

STEVE LINDO Principal, SRL Advisory Services

T his case study is divided into two parts. Part One seeks to bring alive the circumstances leading up to the June 2010 public trial involving Societe Generale, the French banking group, and Jerome Kerviel, the equities trader

whose positions caused Societe Generale to lose €4.9 billion (U.S.$7.2 billion) in January 2008. Part One concludes with an exercise in which the reader is asked to form his or her own opinion on who was to blame for the losses, based on the infor- mation contained in Part One. Part Two reveals the actual outcome of the trial and offers additional study materials for the reader. A Classroom Guide, available sep- arately to instructors wishing to facilitate interactive discussion of the case study in a classroom setting, identifies key risk management lessons from the case study and provides a session plan.

PART ONE: KERVIEL'S TRIAL-A MEDIA CIRCUS On Tuesday, June 8, 2010, the criminal trial of 33-year-old Jerome Kerviel began in Paris's Palais de Justice. The charges against him were forgery, abuse of trust, and illegal use of computers, brought by the Paris public prosecutor. Since the date he was charged, January 28, 2008, Kerviel had been free on bail and preparing his defense.

Despite the long time lapse between the January 2008 events that had caused Societe Generale's losses and the commencement of the trial, media attention was at a fever pitch because of Kerviel's claims that he was a scapegoat for high-risk trading practices that were condoned by Societe Generale when they were prof- itable. Kerviel released an autobiographical book presenting his version of the events shortly before the trial.

Societe Generale, on the other hand, maintained from its earliest public com- munications the posture that Kerviel was a rogue trader who single-handedly developed methods to conduct unauthorized trading without being detected and used them to take massive trading positions that ultimately backfired when mar- kets turned against him. Societe Generale also sought to mitigate the damage to its reputation, due to the apparent facility with which Kerviel conducted his

461

462 Implementing Enterprise Risk Management

Exhibit 23.1 Sample of News Headlines at the Time of Kerviel's Trial

Headline

Rogue Trader Says Ex-Bosses Encouraged Him French Trader Stays Silent as Trials Begin amid

Media Scrum $62 Billion of Suspect Trades Exposed Lack of

Oversight Kerviel Gets Day in Court, SocGen Too Kerviel's Trial-The World of Finance Takes a

Hard Look at Itself (translation) Rogue Trader Denounces "Banking Orgy" in Book

Source and Date

Reuters Gune 8, 2010) The Guardian Gune 8, 2010)

CBC Gune 8, 2010)

Wall Street Journal Gune 7, 2010) L'Express Gune 25, 2010)

Agence France Presse (May 4, 2010)

unauthorized trading, by publishing in May 2008, a detailed examination of the operational and managerial circumstances that had allowed Kerviel's unautho- rized trading to occur and the remedial actions it was taking to prevent recur- rence. Societe Generale stated from the outset its intention to hold the individu- als accountable whom it considered responsible for the unauthorized trading, and took the first step by filing a civil lawsuit against Kerviel on January 24, 2008.

By June 2010, global financial markets were slowly recovering from the 2008 crisis, but memories of Societe Generale's trading losses remained especially vivid because, at the time of their announcement in January 2008, the incident seemed to confirm investors' worst fears that banks in general were taking massive amounts of risk far beyond their traditional lines of business. Exhibit 23.1 shows selected news headlines published at the time of Kerviel's trial, which illustrate this loss of public confidence in banks' risk management discipline.

Societe Generale-The Rise of Trading In the years 1999 through 2006, Societe Generale's net income increased 164 per- cent, from €2 billion annually to €5.2 billion. Though its retail and investment man- agement businesses both prospered during this period, the main driver of Societe Generale's higher profitability was its Corporate and Investment Banking (CIB) division, whose net income increased 230 percent, from €708 million annually to €2.3 billion. Within the CIB, the largest contributors to this profit growth were fixed income, foreign exchange (FX), equities, and commodities trading, which together accounted for 77 percent of CIB's net business revenues in 2006.

These results followed a strategic shift in business focus engineered by Daniel Bouton, who was appointed Societe Generale's CEO in 1993 and became chair- man and CEO in 1999. Bouton was not himself a trader or an investment banker, but a product of the French financial establishment. His early career was spent in government service with the French Finance Ministry. Like most leading public officials and executives of French financial institutions, he was a graduate of the Ecole Nationale d' Administration, France's elite college of public administration.

Among France's top banks, Societe Generale was not alone in pursuing growth in the early 2000s through expansion of its trading and capital markets business. Its larger rival, BNP Paribas, adopted the same strategy, as did major banks in other

CONTROL COMPLACENCY 463

countries such as the United Kingdom, Germany, Switzerland, and the United States. For many of these banks, this strategy backfired when their fixed income desks became deeply involved in structuring, selling, and trading credit deriva- tives and debt securities backed by U.S. residential mortgages, and consequently were unable to avoid massive write-downs and funding crises when global credit markets seized up in the second half of 2008. Though Societe Generale suffered some losses from its fixed income activities, the flaws in its expansion into trading truly came to light in the rogue equities trading incident that is the subject of this case study.

From Business to Retail to Investment Banking, from Private to Public to State Ownership

Societe Generale was founded as a private bank by a group of industrialists in 1864, with the intention of providing finance for industry and commerce. Its early years were marked by a modest expansion of commercial lending activity and bank- ing locations, but little interest in deposit taking or retail banking services. How- ever, it demonstrated resilience in adverse times, such as France's economic slump in the 1880s. The tum of the century marked the beginning of several new direc- tions, as Societe Generale opened up its capital, actively sought to capture deposits, and launched itself into retail lending. It also established its international presence, principally in London and New York. After the upheavals of World War I, Societe Generale rapidly expanded its domestic branch network, domestic lending, and deposit taking, as well as its shareholder base, surpassing Credit Lyonnais in the mid-1920s to become France's leading bank.

The next phase in Societe Generale's development was dictated by external events as France passed through the 1930s economic downturn, World War II, and the postwar rebuilding effort. In 1945, France's three largest commercial banks were nationalized, putting Societe Generale into state ownership for the next 42 years. While economic policy prerogatives constrained the bank's domestic activi- ties during the recovery years, the postwar revival of international trade presented new opportunities for overseas expansion. The next 30 years were transformative for the banking industry in general and for Societe Generale in particular. ATMs and credit cards reinvented the economics of retail banking, and the breakdown of the Chinese wall between investment and commercial banking opened up securi- ties underwriting and trading business to commercial banks. Societe Generale suc- cessfully took advantage of these changes and, in 1987, became the first of France's nationalized banks to be reprivatized.

During the 1990s, the bank's primary strategy was to expand its share of the domestic banking market, which was undergoing a phase of consolidation. In 1997, it met with initial success by acquiring Credit du Nord, but in 1999 suffered a big disappointment when its friendly merger with Banque Paribas was snatched away by a hostile bid from Banque Nationale de Paris (BNP). As a consequence, Societe Generale refocused its growth strategy in the 2000s on three pillars: international retail banking, investment management, and capital markets. The first pillar led to a string of retail banking acquisitions in former Soviet Union countries and Africa. The second pillar resulted in the establishment of a global platform of investor services, including fund management, mutual funds, and securities processing.

464 Implementing Enterprise Risk Management

The third pillar was entrusted to its newly formed Corporate and Investment Bank- ing (CIB) division, intended to achieve prominence in the markets for debt and equity securities and derivatives.

CIB Gets a Boost from Trading Talent

In 1997, Societe Generale's CIB contributed just €151 million to the group's net income of €933 million, barely 16 percent. Then, in 1998 the CIB recorded a loss of €67 million as global markets suffered from the liquidity and volatility back- lash from Russia's debt default and the collapse of Long Term Capital Manage- ment (LTCM). In 1999, shortly after Daniel Bouton was elected chairman of Societe Generale in addition to his role as CEO, the CIB received a boost from the pro- motion of Jean-Pierre Mustier from head of international equity options trading to head of fixed income, FX, commodities, and derivatives. Over the previous 10 years since joining Societe Generale, Mustier, aged 38, had gained high internal recog- nition for building a profitable equity derivatives trading business. CIB's earnings over the next four years proved Mustier's mettle. In 1999, CIB's net income jumped to €708 million, 35 percent of Societe Generale's worldwide net income, and over the next three years CIB accounted for 36 percent of Societe Generale's €6.2 bil- lion cumulative net income, amounting to €2.3 billion. Mustier's contribution to this impressive performance earned him promotion to the position of CIB's global head and membership in Societe Generale's Executive Committee.

Now all under Mustier's leadership, Societe Generale's CIB began to deliver ever-higher profits. In 2003, its net income rose to €1.1 billion, which was 46 per- cent of the group total, followed by €1.4 billion in 2004, €1.8 billion in 2005, and €2.3 billion in 2006. Consistent with Mustier's demonstrated abilities, CIB derived a higher proportion of its revenues from trading than previously. In 2000, trad- ing had accounted for 23 percent of CIB revenues. During the next six years, the percentage averaged 30 percent. This performance was made possible by a rapid expansion in the number of traders CIB deployed and the markets in which they were active. However, as the investigation into Kerviel's unauthorized trading later revealed, this growth in activity was not accompanied by a corresponding reinforcement of CIB's infrastructure and controls.

Societe Generale Group Snapshot, December 2006

As 2006 turned into 2007, Societe Generale's business performance appeared to be riding the crest of a wave. Compared to 2005, net income for 2006 increased 18.6 percent to €5.2 billion, net banking income increased faster than operating expenses (16 percent versus 12 percent), and all business units delivered higher returns. In 2006, Societe Generale raised €2.4 billion of new capital, and Stan- dard & Poor's and Fitch raised their long-term debt ratings from AA- to AA. Over the preceding seven years, the number of Societe Generale's retail customers had increased 2.4 times, the assets under management by its wealth management business had increased 2.8 times, and the number of Societe Generale employees had increased 1.9 times worldwide. As of December 31, 2006, Societe Generale's

CONTROL COMPLACENCY 465

SOCIETE GENERALE GROUP

Strong long-term development at the Group Change

since end-1999 over 1 year ■ 22.5 million individual clients in

Retail Banking and Financial Services , 10.5 million individual customers in France

, 12.0 million individual customers outside France**

■ Global Investment Management and Services • AuM : EUR 422bn (+ EUR 110bn• + EUR 61bn•)

, Assets under custody: EUR 2,262bn

■ Corporate and Investment Banking , No. 3 bank in the euro zone in terms of NB! : EUR 7.0bn in 2006

, One of the most profitable platforms: ROE in excess of 30% for 4 years in a row

■ Around 120,000 staff** in 77 countries , 51 % outside mainland France

• Around 15,000 staff recruited in 2006, incl. 5,350 in France

x2.4 X 1.3 X 9.1

x2.3 x3.8

X 1.6

X 1.9

Exhibit 23.2 Highlights of Societe Generale' s 2006 Performance

+17.2%

+4.0%

+31.7%

+9.3%

+59.5%

+22.8%

+15.9%

14/02/2007

* GIMS' AuM do not include EUR ll0bn of assets held by customers of the French Networks (investable assets exceeding EUR 150,000) or EUR 61bn of assets managed by Lyxor AM, whose results are consolidated in the Equity & Advisory business line (EUR 61bn). ** Excluding Rosbank (Russia). Source: Societe Generale.

total group assets amounted to €869 billion, its risk-weighted assets amounted to €285 billion, and its shareholders' equity amounted to €22.3 billion. Selected 2006 group performance highlights published in Societe Generale' s annual shareholder filing are shown in Exhibit 23.2.

Measured by 2006 net investment banking income, Societe Generale's CIB ranked #3 in the Euro-zone. Compared to 2005, its net income increased by 27 percent to €2.3 billion, bolstered by trading revenue that increased 37.5 percent and worldwide front office head count, which increased by 490 ( + 11 percent). The CIB reported that its fixed income desk had been ranked #2 in corporate eurobond issuance and its equity derivatives business named global equity deriva- tives house of the year by the International Financing Review. Forecasting con- tinued capital markets growth for 2007-2010, the CIB's leadership saw no sub- prime mortgage clouds on the horizon, while its 2006 provisions for credit and trading losses declined from their 2005 level. Selected 2006 CIB performance high- lights published in Societe Generale's annual shareholder filing are shown in Exhibit 23.3.

For a more complete picture of Societe Generale's financial profile, see its 2006 and 2007 income statements and balance sheets, presented later in this chapter.

466 Implementing Enterprise Risk Management

CORPORATE AND INVESTMENT BANKING

Record results

■ Full year 2006

• GOI +31.2%* vs. 2005 with a record 01 06 In EUR m

■ Fourth quarter 2006

• NBI: +26.8%* vs. 04 05

, Operating expenses: +21.7%* vs. 0405

~ Very low C/I ratio: 55.1 % (vs. 57.6% in 04 05 excl. Cowen)

• Risk provisioning : another net reversal

~ ROE after tax in excess of 30% for 15th quarter in a row: 46.2%

Net banking income

o.w. Equity & Advisory

o.w. Corp. Banking & Fixed Income

Operating expenses

Gross operating Income

Net allocation to provisions

Operating income

o.w. Equity & Advisory

o.w. Corp. Banking & Fixed Income

Net Income

ROE (after tax)

C/lratio

0406

+22.8% +25.5%* 1,688

t,31. 1% t,'.ll8%' 691

+16.1% +16.3%* 997

+17.2% +21.1%* (930)

758

-35.9% -35.4%. 16

n4 +52.8% +53.4%* 319

+9.0% +9.4%* 455

585

46.6%

55.1%

II W)~-i(I, f I FULL-YEAR AND FOURTH QUARTER 2006 RESULTS 14/02/2007

Exhibit 23.3 Highlights of CIB's 2006 Performance * When adjusted for changes in Group structure and at constant exchange rates. Source: Societe Generale.

Jerome Kerviel, an Ambitious Outsider

Change Q4/Q4

+26.8%.

+66.9%"

+8.7%*

+21.7%*

+33.7%"

~1.9% *

+27.1%'

x2.B*

-8.1%*

+19.1%"

m

Hidden behind the rosy outlook depicted in Societe Generale's 2006 financial results were two fires smoldering in its CIB. One, exposure to U.S. subprime residential mortgage-backed securities (MBSs), was about to spread like wild- fire throughout the world's financial sector and engulf several larger and more ambitious banks than Societe Generale. The other, unauthorized speculative trading in European equity markets, was about to drive a huge hole through Societe Generale's reputation and profits at the hands of a single trader, Jerome Kerviel.

Kerviel's position in Societe Generale's CIB was unlikely to be noticed. He was one of seven traders in the Delta One Listed Products (OLP) team, a part of the Equity Finance section in the Equity Arbitrage group of the CIB' s Global Equities & Derivative Solutions (GEDS) business unit. At the end of 2006, the CIB had almost 5,000 front office personnel worldwide. GEDS itself had a head count of over 1,300. GEDS's proprietary trading activities comprised two groups-volatility and arbi- trage. As these names imply, GEDS's volatility traders were charged with profiting from directional trading positions, while the arbitrage traders looked to profit from long/ short combinations of offsetting positions by capturing mispricing between assets with similar market sensitivity. A common feature of arbitrage trading is that price differentials are typically very small, which requires large notional amounts of offsetting trades in order to capture meaningful profits.

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Kerviel joined Societe Generale in August 2000 at age 23 to do modeling and process automation in CIB's middle office. In July 2002, he was promoted to trader assistant in CIB's Delta One Equity Derivatives product team, respon- sible for position valuations, price reserves, and risk analysis. In March 2004, he was appointed junior trader for the purpose of proprietary arbitrage trading in listed equity derivative products, including stock futures, indexes, exchange- traded funds (ETFs), and customized equity options such as turbo warrants.

Though inconspicuous in Societe Generale's big picture, Kerviel's career pro- gression was quite an impressive achievement considering his modest origins. He grew up in a small town on the coast of Brittany, and obtained a bachelor's degree in finance in 1999 at the University of Nantes, a provincial town in western France, and a master's degree in financial markets organization and control in 2000 at the University of Lyon. Just as executive positions in France's leading financial insti- tutions were considered reserved for the alumni of elite colleges such as the Ecole Nationale d' Administration that Daniel Bouton had attended, so high-earning trading positions were also considered to be the preserve of graduates from France's top 23 business schools known as grandes ecoles, like Jean-Pierre Mustier.

At First a Few Side Bets, Then Massive Speculation

Kerviel began experimenting with directional positions during his first year as a Delta One trader, creating small index futures and cash equity positions that he closed out before the end of each day. Although these trades were unrelated to Kerviel's arbitrage trading assignment, his supervising manager monitored and discussed them and allowed Kerviel to continue. In 2005, Kerviel became bolder, venturing into overnight trades. Initially, it seems that this progression was also tolerated because of the small amounts, but a €10 million overnight cash equity position drew his manager's concern in July 2005. Kerviel's next move took him over the line into fraudulent activity. In order to continue taking overnight direc- tional positions without arousing management concerns, he began to create fic- titious trades to offset them in DLP's books. This practice continued in sporadic fashion and in relatively small amounts through the end of 2006, peaking at €140 million in August, unnoticed by Kerviel' s manager or any of DLP' s middle or back office personnel. Meanwhile, in the other sector where trouble was brewing for Societe Generale, the first signs of distress were emerging in the U.S. residential mortgage finance market, as several subprime lenders started to report high delin- quencies and the U.S. home construction index tumbled.

In January 2007, Kerviel's manager left Societe Generale to take another job. For the next two months, Kerviel was effectively unsupervised. Finally, in April 2007, a new manager was assigned to Kerviel's DLP team, but this one had no prior trading experience and received no orientation on his critical duties. Mean- while, in the European equity markets where Kerviel traded, the accelerating U.S. residential mortgage meltdown had not yet had any impact, but the opportunity to bet on a stock market correction proved irresistible. By January 24, Kerviel's directional short position in European equity index futures had reached €850 million. During February, Kerviel increased his short position to €2.6 billion (U.S.$3.4 billion), and by the end of March it had risen to €5.5 billion. As news from the U.S. residential mortgage market continued to deteriorate in June and two Bear

468 Implementing Enterprise Risk Management

Stearns collateralized debt obligation (CDO) funds collapsed, Kerviel became even bolder. By July 19, his short equity index position hit a peak of €30 billion. So far in 2007, Kerviel's accumulated mark-to-market loss was €2.2 billion, which was hidden in the fictitious forwards that he entered into GEDS's transaction system.

The forward counterparties Kerviel selected were either "pending," Societe Generale affiliates, or genuine but unsuspecting counterparties. To avoid detec- tion, Kerviel assigned deferred start dates to these forwards, for which GEDS's internal policies did not require formal counterparty confirmations until the start date, which he could manipulate by canceling and reentering new fictitious trades. The sheer volume of this trading was not completely unnoticed. In fact, 41 queries about transaction anomalies, accounting discrepancies, and broker commissions were raised by Societe Generale's back office during the period from June 2006 to January 2008, but in each case they were satisfied by Kerviel's trade amend- ments, cancellations, and explanations. A summary of the queries is shown in Exhibit 23.4.

During the next four weeks, Kerviel's massive stock market bet finally paid off, as stocks around the world fell 8 percent. His short equity futures posi- tions erased their losses and began to show profits, allowing Kerviel to gradu- ally unwind them and accumulate €750 million in profits, which he concealed in fictitious counterparty trades and provisions. In November, stocks began to recover and Kerviel reversed his strategy by building a €30 billion portfolio of unauthorized long equity futures positions matched by fictitious offsetting trades, which he liquidated in December with a further €750 million in profits. Again, the volume of Kerviel's activity attracted notice, this time in the form of an alert from Eurex about a large (€1.2 billion) purchase of equity index futures by DLP in November, which Kerviel's manager failed to follow up.

Exhibit 23.4 Internal Queries Raised about Kerviel's Fictitious or Unauthorized Trades, 2006-2008

No.of Dates Queries Focus of Query Source Department

June2006 1 Pricing discrepancies GEDS Operations Dec. 2006 to June 2007 5 Earnings discrepancies CIB Accounting Jan. to Oct. 2007 9 Unidentified counterparty or GEDS Operations

broker Jan. to Nov. 2007 7 Unexplained balance sheet CIB Accounting

variations Jan.2007toJan.2008 3 Trade entry errors GEDS Operations Feb.2007 1 Trade settlement discrepancy GEDS Operations March to Oct. 2007 12 P&L and provision GEDS Operations,

discrepancies, high notional CIB Accounting amount of transactions

June to Aug. 2007 2 Reconciliation differences GEDS Operations Dec.2007 1 High broker commissions DLPtrading

management

Source: "Mission Green" report, General Inspection Services, Societe Generale.

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As 2007 came to a close on December 31, Kerviel was careful to close out all his unauthorized trades, ending with a €1.5 billion profit hidden in fictitious for- wards with Societe Generale affiliates. This was his prize for having held unau- thorized directional positions in European stock indexes, in a volume equal to the bank's entire capital, during two prolonged periods of the year. Meanwhile, else- where in Societe Generale, concerns were mounting that CIB's exposure to U.S. subprime mortgage-backed securities could prove very costly. The first admission of its troubles occurred in October 2007 when CIB's fixed income, currencies, and commodities business unit took a €230 million write-down in its U.S. residential mortgage-related assets. Even though European equity markets ended the year close to their levels before the July correction, Societe Generale's year-end share price was still down 37 percent from its May 2007 peak.

Discovery, Damage Control, and Retribution

As soon as 2008's equity markets opened, Kerviel resumed his unauthorized direc- tional trading, confident in his ability to keep calling market movements correctly and hiding his profits. Convinced that the European stock markets would extend their November rally into 2008, he began a series of unauthorized equity index futures purchases that reached a new peak of €49 billion on January 18, offset- ting these positions with fictitious trades as before. However, unconnected to this even bolder move, his strategy was about to unravel because of an administrative, not operational, slip. In the first days of 2008, Kerviel changed the counterparty of the fictitious trades concealing his €1.5 billion 2007 profits from a Societe Generale affiliate to an unsuspecting third-party counterparty. During 2007, he had made this kind of change many times without tripping any alarms. On this occasion, however, the counterparty he selected did not have a collateral agreement in place with Societe Generale, which triggered a massive overage in the counterparty's credit value at risk (CVaR) limit.

Caught by surprise when queried by Societe Generale's group risk manage- ment department, which was responsible for monitoring counterparty exposures, Kerviel decided to cancel the fictitious trades and create a provision in order to keep his 2007 profits out of sight. Without any signs of concern over this incident, Kerviel calculated an amount for the provision that would leave €15 million of his undisclosed profits to be accounted for in DLP's 2007 yearbook-end trading results and assure him of a high ranking among DLP's traders. Seemingly in the clear again, Kerviel did not know that a second trip wire was about to end his long and eventful trading journey. The query that unraveled his strategy did not come from risk management or operations, but from financial reporting.

January 15 marked the first consolidation of Societe Generale's 2007 year- end financial reporting, which included regulatory capital. It also coincided with another slump in global equity prices, triggered by fears that U.S. and international banks were more exposed to subprime mortgage losses than previously disclosed. As Societe Generale's preliminary risk-weighted asset (RWA) numbers began to be checked, the massive counterparty exposure that had triggered risk manage- ment's CVaR inquiry showed up in the bank's RWA numbers. When queried, Kerviel explained that the trades had been canceled, but the financial reporting group was not satisfied with his explanation. A flurry of e-mails and phone calls

470 Implementing Enterprise Risk Management

took place over the next two days between financial reporting and the DLP mid- dle office and back office, during which Kerviel insisted that the trades had been canceled but gave no satisfactory explanation. Finally, a meeting took place where Kerviel discovered that the outsize RW A number was the result of his fictitious counterparty not having a collateral agreement in place; he thereupon changed his explanation, claiming that the wrong counterparty had been entered for the for- wards and identifying another counterparty as the correct one. The meeting ended with Kerviel promising to provide documentary evidence of the replacement coun- terparty' s agreement to the trades.

However, the financial reporting team were skeptical of Kerviel's new expla- nation and decided to escalate the incident to GEDS's senior management, given the very large size of the transactions. The next day, Friday, January 18, Kerviel modified the trades and sent e-mails that appeared to confirm that the forwards had been agreed with the replacement counterparty. Still concerned, representa- tives of financial reporting, DLP operations, and GEDS's senior management met at the end of the day and decided to independently confirm the existence of the for- wards with the replacement counterparty the next morning, which was Saturday, January 19. Meanwhile, the week's close of business brought more gloom to Societe Generale's stock price, which dropped another 8.2 percent as the French central bank announced that Societe Generale and another major French bank would have to further write down the valuation of their U.S. assets. On Saturday, January 19, within hours of the fictitious nature of his December 2007 trades being revealed by the counterparty's negative confirmation response, Kerviel divulged the full extent of his €49 billion directional equity index positions, which was immediately com- municated to Societe Generale' s executive management. A summary of the queries, conversations, and meetings that resulted in discovery of Kerviel's unauthorized trading is shown in Exhibit 23.5.

Sunday, January 20, began a series of four days of unthinkable consequences for Societe Generale. After being advised of the known facts and extent of Kerviel' s unauthorized trading, Bouton notified Societe Generale's board and offered his resignation, which was declined and he was told to take charge of controlling the damage. The following day, Bouton obtained an unprecedented permission from France's Financial Markets Authority (Autorite des Marches Financiers, AMF) to secretly unwind Kerviel's directional equity index position over the next three days before making a public announcement about Societe Generale' s unauthorized positions. As GEDS's traders set to work, no matter how discreetly they executed their sales, Societe Generale inevitably suffered heavy losses due to the size of its positions and the equity markets' bearish trend. By close of business on January 23, all of Societe Generale's unauthorized equity index positions were gone and a €6.4 billion loss was recorded, equivalent to 13 percent of the notional value of the positions that Kerviel had created just weeks earlier. Recognizing the damage that such a huge loss could have on market confidence in Societe Generale's solvency, Bouton used the time before publicly announcing the losses to secure commit- ments to raise €5.5 billion of new capital. He also briefed the French, European, and U.S. monetary authorities ahead of the public announcement. On January 24, Bou- ton held a press conference and issued a letter to Societe Generale's clients briefly describing the incident and declaring it to be under control. The letter also stated that Societe Generale's capital was to be replenished by the new equity issuance.

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Exhibit 23.5 Sequence of Queries, Conversations, and Meetings Resulting in Discovery of Kerviel's Unauthorized Trading

Date Parties Involved Issue Outcome

Jan.8,2008 • Societe Generale Risk Exposure (CVaR) over Issue dosed-trades Management limit for fictitious canceled by Kerviel.

• GEDS middle office counterparty • Kerviel

Jan. 15,2008 • CIB Regulatory Very high RWA and CIB-RR sought Reporting (CIB-RR) Cooke ratio for clarification of

• GEDS middle office fictitious Kerviel' s previous counterparty explanations and

trade cancellations. Jan. 16, 2008 • CIB Regulatory Correct financial Not convinced by

Reporting reporting of very further telephone • GEDS middle office large trades, explanations, CIB-RR • Kerviel clarification of scheduled meeting

trader's with Kerviel for explanations January 17.

Jan. 17, 2008 • CIB Regulatory Correct financial Kerviel advised that the Reporting reporting of very wrong counterparty

• GEDS middle office large trades, was entered for the • Kerviel clarification of trades and would be

trader's corrected. CIB-RR explanations requested supporting

documentation. Jan. 18, 2008 • CIB Regulatory Trade cancellations, CIB-RR briefed

Reporting (CIB-RR) counterparty GEDS-TM, who spoke • GEDS Trading substitution, with Kerviel and

Management unconvincing received the same (GEDS-TM) trader explanations unsatisfactory

• Kerviel explanations. Kerviel canceled and reentered the fictitious trades with the replacement counterparty and sent CIB-RR a falsified confirmation. CIB-RR and GEDS-TM met in the evening and decided to seek direct confirmation from the replacement counterparty.

Jan. 19,2008 • CIB Regulatory Proof of fictitious Confronted by proof of Reporting transactions, his fictitious

• GEDS Trading discovery of transactions, Kerviel Management unauthorized revealed the nature (GEDS-TM) trading positions and extent of his past

• Kerviel and current • Societe Generale unauthorized trading

Executive positions that were Management offset by fictitious

trades.

Source: "Mission Green" report, General Inspection Services, Societe Generale.

472 Implementing Enterprise Risk Management

In a subsequent interview he disclosed that Societe Generale would take a further €2 billion write-down in its U.S. residential mortgage exposures for 2007 year-end. Bouton's revelations were generally greeted by astonishment that a financial insti- tution of Societe Generale's standing could have failed to prevent such egregious risk taking by a single individual.

In the following days, Societe Generale filed a civil lawsuit against Kerviel, and Paris's public prosecutor filed criminal charges against Kerviel. Societe Generale's board formed a special committee to investigate the incident, which commissioned an internal audit report and a diagnostic review of GEDS's internal control envi- ronment by Pricewaterhouse Coopers (PwC). The internal audit team's prelim- inary findings were published on February 21, its final report, and PwC's find- ings published on May 20. On April 17, Bouton relinquished his role as CEO but remained chairman for another year. On May 30, Mustier relinquished his position as global head of CIB. Several months later, Mustier was reassigned to head Societe Generale's investment management business, but resigned from Societe Generale a year later.

Postmortem

During the spring and summer of 2008, further details released about Societe Generale's unauthorized trading losses continued to tarnish its reputation, while the outlook for banking as a whole darkened significantly, as delinquencies in U.S. residential mortgages spread losses and fear across the entire sector. The New York investment bank Bear Stearns ran out of funds in March 2008 and had to be rescued by JPMorgan Chase. IndyMac Bank failed in July, and Fannie Mae and Freddie Mac were put into receivership in September, closely followed by the bankruptcy of Lehman Brothers, rescue of Merrill Lynch by Bank of America, and the Federal Reserve's bailout of American International Group (AIG).

Meanwhile, the internal and external investigations into how Societe Generale's management and control environment allowed Kerviel to conduct his unauthorized trading for so long and in such large amounts revealed an extraor- dinary range of failings. This was so much that the French Banking Commis- sion (Commission Bancaire, CB) fined Societe Generale €4 million in July 2008, an insignificant sum relative to the magnitude of Societe Generale's trading losses, but close to the CB's legal maximum.

The principal findings of the internal and external investigations were as follows.

Managerial Supervision

GEDS's trading management had primary responsibility for continuously mon- itoring its trading positions; performing daily analysis of the coherence of risks, earnings, and positions; and ensuring that all transactions complied with the department's policies and limits. However, there was no explicit requirement to monitor cash movements. Societe Generale's systems provided trading manage- ment with a series of transaction, profit and loss (P&L), and cash flow reports and, during 2005-2006, monitoring appears to have been done in a desultory manner by Kerviel's trading manager. However, after this manager's departure in January 2007, Kerviel's trading activity received no monitoring at all. Trading management

CONTROL COMPLACENCY 473

was also tasked with responding to internal and external alerts and queries about the positions under their responsibility. In Kerviel's case these were rare; however, an alert from Eurex about a large transaction in November 2007 related to Kerviel's unauthorized directional positions was never followed up. PwC noted in partic- ular that the rigor of DLP's front office oversight diminished as trading volume increased, allowing unauthorized activities such as day trading, P&L smoothing, and position transfers between traders to proliferate.

Control Environment

The primary control framework in which Kerviel operated had a number of serious deficiencies:

• There were no limits on notional transaction volumes or cash movements. • Trade cancellations, modifications, deferred start dates, and provisions were

not subject to exception treatment. • There was inadequate separation of duties between DLP's front office and

middle office: Kerviel was able to modify and cancel trades at will in GEDS' s transaction system and create provisions that concealed his unauthorized profits.

• Policies and procedures for escalation of concerns were either unclear or nonexistent.

• There was no policy dictating minimum consecutive days of vacation.

The secondary control framework supporting DLP also had serious deficiencies.

• GEDS's back office support for DLP was separated into four different oper- ations groups, which did not communicate with each other and whose pro- cedures required them to raise and resolve but not to question trade-related queries.

• Societe Generale's counterparty risk management group was required to raise and resolve exposure issues but not to validate the cause or solu- tion. This group raised 20 queries that they considered resolved by Kerviel's explanations and amendments.

• Societe Generale's market risk management performed a risk reporting and advisory role, but did not exercise trading oversight; consequently they were not involved in monitoring the alerts and unusual activity created by Kerviel's unauthorized positions and fictitious offsetting trades.

• During 2006 and 2007, GEDS's back office was chronically understaffed due to high employee turnover, while DLP's trading volume doubled, its range of traded products multiplied, and the number of traders increased from four to 23.

System Reliability

GEDS' s transaction systems also had serious deficiencies:

• Faulty security protocols allowed Kerviel to continue to access and change system records after he was promoted from the middle office to the front office.

474 Implementing Enterprise Risk Management

• Chronic accuracy, reliability, and timeliness problems predisposed opera- tions and risk personnel to expect system errors to be the cause of processing exceptions, not suspicious activity.

• Daily reports of cash movements from margins and broker commissions were aggregated across portfolios, hindering identification of the unusual levels of activity created by Kerviel's unauthorized trades.

Risk-Sensitive Culture

The investigations also identified cultural deficiencies, specifically citing that DLP's trading oversight and control personnel were not trained or instructed to be alert for fraud and were slow and lax in responding to and resolving queries.

Action Plan PwC reviewed and endorsed Societe Generale's two-part remedial action plan, consisting of a series of immediate fixes and longer-term structural changes. The key elements of this action plan were:

• Immediate strengthening of GEDS's front office supervision across all equi- ties, fixed income, derivatives, and commodities trading desks, by means of heightened awareness of responsibilities, introduction, and use of formal monitoring tools

• Immediate strengthening of GEDS's middle and back office controls by means of remedying controls found to be missing or ineffective

• Immediate strengthening of system access controls and information technol- ogy (IT) security

• Immediate strengthening of governance by specifying roles, responsibilities, and escalation protocols across all relevant positions

• A four-part transformation strategy to improve GEDS's control infrastruc- ture, culture, and IT security, consisting of: 1. More control-sensitive operations processes 2. Creation of a cross-divisional operational surveillance program designed

to identify and rectify anomalous situations and chronic conditions that could be symptomatic of or conducive to fraud

3. Long-term IT security improvement plan 4. Professional ethics and accountability education program for traders and

their support staff • Formation of two committees tasked with ensuring implementation of these

four initiatives

Who Was to Blame?

The two years between publication of the two investigative reports into Kerviel's unauthorized trading and his trial were tumultuous for U.S. and European banks. A steady succession of huge asset write-downs, government bailouts, liquidity life- lines, and arranged takeovers of once-proud banks and insurance companies took

CONTROL COMPLACENCY 475

place. Stock and housing prices tumbled, unemployment soared, and the U.S. and European economies slipped into recession. After multilateral government stabi- lization measures began to take effect, lawsuits began to emerge alleging dishonest lending and securitization practices. As Kerviel's June 8, 2010, trial date neared, Societe Generale kept a low profile. Kerviel, on the other hand, sought to publicize his assertion that Societe Generale unofficially endorsed his directional trading, with the publication of a book entitled The Spiral: Memoirs of a Trader.

Exercise

Now begins the interactive portion of this case study. The preceding narrative and exhibits have presented key facts that were publicly known at the beginning of Kerviel's trial. Whether or not the information they provide is conclusive one way or another is up to the reader to decide. In a real trial, prosecution and defense attorneys methodically lay out their respective evidence and arguments. To facili- tate the reader's assessment of both arguments in this case study, a blank Critical Questions table is provided in Exhibit 23.6. The purpose of this table is for the

Exhibit 23.6 Critical Questions and Answers-Worksheet

Question Answer Implying Guilty Answer Implying Not Guilty

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

476 Implementing Enterprise Risk Management

reader to list critical questions that the trial judges should have asked in order to determine the truth behind each party's claims, and then to identify answers that would incriminate ("Guilty") or exonerate ("Not Guilty") Kerviel. Once this exer- cise has been completed, the reader may tum to Part Two.

PART TWO: OUTCOME AND LESSONS LEARNED Part Two of this case study reveals the outcome of the trial and its consequences, provides a prepared list of critical questions on page 487 to compare with those compiled by the reader at the end of Part One (Exhibit 23.6) and additional learn- ing materials in the form of: (1) a list of the reference materials used to compile this case study, (2) Societe Generale' s full-year 2006 and 2007 financial statements (Exhibits 23.7), and (3) a chronology of events leading up to, during, and after the period in which Kerviel's unauthorized trading took place (Exhibit 23.8).

I SUMMARY INCOME STATEMENT OF SOCIETE GENERALE

2007 2006 07/06 07/06 Soclete 07/06 Soclete

(On millions of errors at December 31) France (%) International (%i GeneraJe (%) France International GeneraJe Net banking Income 9.062 4,8

Operating experses (5,539) (4.0)

Gross operating income 3,623 22.6

Cost of risk (96) (1,300.0)

Operating Income 3,427 18.9

Net income from long-term investments 229 (44.3)

Operating income before tax 3,656 11.0

Exceptional items (4,801) NS

Income tax 1,473 (918.3)

Net allocation to regulatory provisions (9) (10.0)

Net Income 319 (89.7)

Societe Generale net income lor the 2007 financial year came out at EUR-961 million , down 123.8% on 2006 . The breakdown of results for Societe Generale in France and abroad is given in the above table.

The principal changes in the income statement were as lollows:

• Societe Generale was directly impacted by the effects ol the US subprime mortgage crisis, leading to gross operating income down lrom 2006 to EUR 2,007 million:

• net banking income amounted to EUR 8 ,770 million , down sharply on 2006, due to the consequences of this crisis on the Corporate and Investment Banking arm . The solid commercial performance generated by this activity was thus erased by trading activities, owing to write down and losses:

- EUR -1 ,250 million on unhedged super senior COO tranches:

- EUR -947 million on counterparty risk exposure to US monolines:

- EUR -325 million on the RMBS trading portfolio.

Retail Banking in France remained on a steady growth trend , in terms ol both individual customers and business customers. Customer acquisition (+ 126,000 sight accounts in 2007) went hand in hand with the overall increase in customer savings. At the same time, outstanding loans to business customers remained on an uptrend in 2007.

(292) (111.8) 8,770 (21.2) 8,648 2,480 11 ,126

(1,224) (4.5) (6,763) (4. 1) (5,TT3) (1 ,281) (7,054)

(1,516) (226.5) 2,007 (50.7) 2,873 1,199 4,on (40) (229.8) (136) (450.4) 8 31 39

(1 ,556) (226.8) 1,871 (54.5) 2,881 1,230 4,111

(183) NS 46 (88.9) 411 3 414

1,739 (241.1) 1,917 (57.6) 3,292 1,233 4,526

NS (4,801) NS

459 (251.9) 1,932 (500.7) (180) (302) (482)

NS (9) (10.0) (10) (10)

(1,280) (237.5) (961) (123 .8) 3,102 931 4,033

• management fees totaled EUR 6 ,763 million , down lrom 2006, mainly due to the change in variable costs recorded by Corporate and Investment Banking, a direct rellection of the situation in 2007. Retail Banking in France expanded in 2008 with the opening of over 50 new branches:

• net income lrom long-term investments came out at EUR 46 million in 2007. This breaks down into EUR + 131 million in income from the disposal of subsidiary shares (of which a net capital gain of EUR +93 million lrom the exchange of Euronext shares for NYSE shares and the subsequent sale ol the new entity's shares) and EUR -89 million stemming from the write-back of provisions for other shares in conso- lidated subsidiaries:

■ exceptional items include the loss before income taxes of the unwinding of the directional positions on unauthorized and concealed trading activities discovered on January 19 and 20, 2008:

■ the EUR 9 million allocation to provisions for banking risks corresponds to an allocation to an investment provision , in accordance with article 237 bis All of the French Tax Code. A provision of EUR 10 million had been booked at December 31 , 2006.

Exhibit 23.7 Societe Generale's 2006 and 2007 Summary Income Statement

II El II II II E1 II El El Im m m m

CONTROL COMPLACENCY a eaa11o GI

--- 1 0

■ PARENT COMPANY FINANCIAL STATEMENTS

Soclete Generale management report

I w BWICE SHEET Of SOCETE GEIEIW.E

a.... ...

i-,-...,... .. ....,..._

! U.LBIIIT1£HID51tAR9101JlQS' Eq,:m J

-----'-................ OIW...._rie- l.i Oecenbor JI, 2007. Socio1e Gonoral• Parent~- ll!W!t!i lllld llllmf!l m10lml!i:f to Elll 1.0Z12 billon, ~ ,,~ an0ecember31. 2006.a um 1araoghlyl!q": 'iD~ "'P'""""'""-•1~3l, 2006The~ al Sa>.., G.ono<...,, acwi""" are rol!eclarf in Iha key figun,s m rheho!aneesi-t.

Exhibit 23.7 (Continued)

2IIDII a.a,. nu uu '" 22U lU :iu ◄11..t l1l2JI IU

IOU P;'.JJ W.1 nu JO ,ru l3JJ ....

u tl Dl .... t 5U

- -:nu 5111 1111 ,,,

2U IV u tll!JI U,A IN-9 m, /U.2 I.I

2IU 11.'I IU

llU ./lJJ

2" fl.fl t,m.z .... 15U

■ d,eina.....,1no.-.mgo.J!IDTWmns{l<J.n.).whd!""""' a.ut i!II ElM 225..S lffl llf. DKmi>f!r 31, axJJ, WH dl!rrv@d mainly t-cm lhe ,,... n ohort•lt!lffl loMa (EUR + 1 • .3 bmion). mongage loano (EUR +6.2 btllion) ond equipment m~ (BJR ..3.4 bilim);

IOCElI.IIIIB&l. .... •~Nilll- 1.:1

477

II II II II 11 II II II II Im Ill m 11

478 Implementing Enterprise Risk Management

Exhibit 23.8 Chronology of Events

Date

1991

1993 Nov.1997 1999

1999

Aug.2000

July2002

May2003 2003

March2004

June2005

July2005

Internal/ External

Internal

Internal Internal External

Internal

Internal

Internal

Internal Internal

Internal

External

Internal

Jan.-Dec. 2006 Internal

May2006 External

Description

Daniel Bouton joined Societe Generale (SG) as EVP, after serving in a number of different positions in the French Finance Ministry, including that of Budget Director, from 1988 to 1991, Chief of Staff of Alain Juppe, Deputy Minister in charge of the budget from 1986 to 1988, in the Budget Department from 1977 to 1986, and in the Finance Inspectorate from 1973 to 1976.

Bouton appointed CEO of SG Group. Bouton appointed chairman and co-CEO of SG Group. SG's proposed friendly merger with Banque Paribas torn

apart by hostile bid for both banks from BNP. SG escaped but Paribas succumbed, leaving SG's growth strategy in disarray.

Jean-Pierre Mustier promoted from head of CIB equity options trading in SG's Corporate and Investment Banking (CIB) to head of fixed income, FX, commodities, and derivatives.

Jerome Kerviel GK) hired to do modeling and process automation in CIB's middle office, aged 23.

JK promoted to trader assistant in SG's Delta One equity derivatives product team, responsible for valuations, provisions, and risk analysis.

Daniel Bouton appointed CEO of SG bank. Mustier promoted to head of CIB, beginning a period of

aggressive and successful expansion in securities underwriting, derivatives, and proprietary trading. Over the next five years, CIB's glamor and earnings eroded SG's traditional control-oriented, retail banking culture.

JK promoted to junior trader in Delta One Listed Products (DLP)team.

A handful of U.S. investment banks set up short residential mortgages positions, even as their own and other banks' fixed income desks continue to source, warehouse, structure, and distribute subprime mortgages and MBSs.

First unauthorized trades by JK, offset by fictitious trades with counterparties either SG subsidiaries, unidentified/pending, or third parties. JK's fictitious trades had deferred start dates, which did not require immediate confirmation.

JK continued sporadic unauthorized trading, with insignificant gains or losses.

First cutbacks and failures among U.S. subprime mortgage lenders; Merrill Lynch, unable to sell super-senior tranches of new subprime COOs, set up a buy-and-hold trading desk. Some investment banks started producing COOs designed to fail, so they could buy and profit from the investors' credit protection.

Exhibit 23.8 (Continued)

Internal/ Date External

Aug. 2006 Internal

Sep. 2006 External

Jan. 2007 Internal

Feb. 2007 External

Feb.-March Internal 2007

April-June Internal 2007

May4,2007 External June2007 External

July2007 External July2007 Internal

Aug.2007 External

Sep. 2007 External Sep.-Nov. Internal

2007

Oct. 2007 Internal

CONTROL COMPLACENCY 479

Description

JK's unauthorized trading volume moved up a notch to €140 million (U.S.$179 million) in equity index futures.

U.S. residential housing construction index down 40 percent year-over-year. Some investment banks began reducing their securitization activities and limiting their exposures to U.S. residential mortgages.

JK's immediate CIB trading manager left SG and was not replaced until April by another CIB manager who had no prior experience of trading management and received no detailed direction on his responsibilities until November 2007.

Trickle of losses and failures in U.S. subprime lending sector turned into a flood--Ownit, American Freedom Mortgage, Network USA, HSBC, Accredited, New Century, DR Horton, Countrywide.

Anticipating a stock market crash, JK progressively built up unauthorized short equity index futures positions amounting to €5.5 billion (U.S.$7.3 billion), masking the directionality of these trades with fictitious offsetting trades.

JK further increased his unauthorized short equity index futures positions amounting to €30 billion with a cumulative P&L of €2.2 billion (U.S.$3 billion). Between February and June, 39 instances of discrepancies in settlement details, accounting entries, and broker commissions were flagged by SG's controllers, but deflected by JK's trade amendments, cancellations, and explanations.

SG's stock hit its peak of €140.55 per share. Bear Stearns halted redemptions in two COO hedge funds,

which immediately become insolvent. Equity markets slumped. JK unwound substantially all of his short equity index futures

positions in the last week of July, having erased all of his losses.

Onset of credit crunch as traces of subprime MBSs in bank portfolios around the world set off a counterparty exposure panic that caused interbank and repo markets to freeze up. Investors everywhere started liquidating other assets in order to take refuge in U.S. Treasuries. The U.S. Federal Reserve made the first of many liquidity interventions, followed by the European Central Bank (ECB).

First month of negative U.S. job growth since August 2003. JK's remaining short equity index futures positions

accumulated €750 million of profits before he unwound them in November 2007 when equity markets began to recover.

First effects of financial sector crisis on CIB revenues: €230 million write-down in SG's U.S. residential mortgage-related assets.

(continued)

480 Implementing Enterprise Risk Management

Exhibit 23.8 (Continued)

Date Internal/ External

Oct. 24, 2007 External

Nov. 2007 Internal

Dec. 2007 Internal

Dec. 2007 External

Jan. 2-10, 2008 Internal

Jan. 2-18, 2008 Internal

Jan.14-17, 2008

Jan. 15,2008

Jan. 18,2008

Internal

External

External

Description

Merrill Lynch announced Q3-07 loss of U.S.$5.5 billion, later revised to U.S.$8.4 billion.

JK built a €30 billion portfolio of unauthorized long equity futures positions matched by fictitious offsetting trades. An alert from Eurex about a large (€1.2 billion) purchase of equity index futures went unheeded.

JK liquidated his unauthorized portfolio of long equity futures positions, concealing the resulting €1.5 billion of profits in fictitious forward trades with an SG affiliate.

SG's market capitalization down 23 percent since June 2007 on fears that its exposure to U.S. subprime mortgages was much greater than disclosed.

On January 2 JK switched his December 2007 fictitious forward counterparties from the SG subsidiary to a third party, unaware that the third-party counterparty he chose did not have a collateral agreement with SG, thus causing a huge CV aR exposure to show up in risk reports. Note: This issue did not occur in early 2007 when JK's unauthorized trades were losing money and SG's risk reports showed negative counterparty credit exposure to fictitious third parties. When the massive CVaR exposure was queried, JK canceled the fictitious forwards and instructed his {24-year-old) trading assistant to create a valuation provision of €1.485 billion to conceal the bulk of his 2007 gains, resulting in €15 million reported year-end trading profits versus actual trading profits of €1.5 billion.

JK rebuilt a €49 billion portfolio of unauthorized long equity index futures positions with fictitious offsetting trades.

The fictitious CVaR exposure disappeared from SG's daily counterparty credit risk reports but was still queried for 2007 year-end RWA and Cooke ratio reporting. JK met with SG's financial reporting group and explained that the counterparty he recorded for the forwards was incorrect and should have been a different third party (with a collateral agreement).

Global slump in equity markets triggered by fears that U.S. and international banks were more exposed to subprime mortgage losses than disclosed.

SG's stock dropped another 8.2 percent as Banque de France announced that SG and another major French bank would have to write down the valuation of their U.S. assets.

Exhibit 23.8 (Continued)

Date

Jan. 18,2008

Jan. 19,2008

Jan. 19,2008

Jan.20,2008

Jan.21,2008

Jan. 21-23, 2008

Jan.23,2008

Jan.24,2008 Jan.24,2008

Internal/ External

Internal

Internal

Internal

Internal

External

Internal

External

External Internal

CONTROL COMPLACENCY 481

Description

SG's financial reporting group escalated their concerns about JK's unusual transactions and explanations to CIB senior management. Meanwhile, JK canceled the fictitious December 2007 forwards, reentered them with the replacement counterparty, and falsified a confirmation document from the replacement counterparty. JK's supervisors decided to call the replacement counterparty to verify the existence of JK's forwards.

SG's replacement counterparty advised that the forwards recorded by JK did not exist.

JK's current portfolio of unauthorized long equity index futures positions with fictitious offsetting trades was discovered, amounting to €49 billion, equivalent to 181 percent of SG's capital of €27 billion, and already €2 billion underwater.

SG's chairman and CEO Daniel Bouton tendered his resignation, which was rejected by the board and SG's union leaders, who insisted that he stay to resolve the rogue trading problem.

European equity markets suffered further heavy declines (-6 percent). Bouton received approval from SG's regulator, Autorite des Marches Financiers (AMF), to withhold disclosure of SG's unauthorized equity index portfolio for three days so that it could be liquidated without panicking already nervous equity markets.

JK's €49 billion portfolio of unauthorized long equity index positions was liquidated, crystallizing losses of €6.4 billion.

Bouton briefed France's President, Economy Minister, the ECB president, and chairman of the U.S. Federal Reserve on the origin and extent of SG's rogue trading losses.

SG filed a civil lawsuit against JK for fraud. An investigation by SG's General Inspection Services

(internal audit) was commissioned by the Executive Committee of the board to: (1) determine the exact nature and methods used by JK to conduct his unauthorized transactions, (2) verify the accuracy of the positions and subsequent losses, (3) investigate }K's motives and the role of any possible accomplices, (4) identify the cause of and responsibility for the internal control breakdowns, (5) verify the nonexistence of similar practices anywhere else inCIB.

(continued)

482 Implementing Enterprise Risk Management

Exhibit 23.8 (Continued)

Date

Jan.24,2008

Jan.25,2008

Jan. 26, 2008

Jan. 28, 2008

Jan. 30, 2008

Feb.21,2008

Feb.21,2008

Feb.-March 2008

March 16, 2008

April2008

May 13,2008

Internal/ External

External

External

External

External

Internal

Internal

Internal

External

External

Internal

Description

Trading in SG's shares was temporarily suspended as Bouton issued a public letter and newspaper interview describing the origin and extent of the losses and remedial actions being taken, including legal action against JK, separation of employees responsible for supervision and control of the department where JK's unauthorized trading occurred, and raising €5.5 billion of new capital.

Police raided JK's apartment and SG's offices to seize JK's computer records.

JK voluntarily surrendered to the police and was held in custody.

JK was charged by the Paris prosecutor with forgery, abuse of trust, and illegal use of computers, and was released on bail.

Independent board committee formed to investigate JK's unauthorized trading. Operational review of the circumstances and control failings commissioned from PwC.

SG announced a Q4-07 loss of €3.4 billion, due to JK's unauthorized trading and increased its December 2007 write-downs on U.S. residential mortgage-related exposures to €2.3 billion.

Preliminary findings of investigation by SG's General Inspection Services (internal audit function) published.

A steady stream of public sparring took place between senior SG, banking, and government officials regarding a possible takeover bid for SG and Bouton's responsibility for SG's rogue trading scandal.

Bear Stearns rescued by JPMorgan Chase with U.S.$30 billion New York Fed backstop.

Bouton resigned as CEO, but remained as SG chairman.

SG announced another €596 million write-down to its U.S. residential mortgage-related exposures and completion of its €5.5 billion new equity raising.

Exhibit 23.8 (Continued)

Internal/ Date External

May 20, 2008 Internal

CONTROL COMPLACENCY 483

Description

The investigation report by SG's General Inspection Services entitled "Mission Green" was presented to SG's board of directors. Key findings: (1) JK's unauthorized trading progressed through five stages-(i) intraday directional trades, (ii) overnight directional positions, (iii) disguising overnight directional positions with fictitious offsetting trades (947 instances), (iv) concealing gains from unauthorized directional positions with fictitious loss-making buy-sell trades (115 instances), and (v) concealing gains from unauthorized directional positions with valuation provisions (9 instances); (2) in 2007 JK built and liquidated two €30 billion unauthorized portfolios of equity index futures, concealed by fictitious offsetting trades, which generated net profits of €1.5 billion, and between January 2 and 18, 2008, he built a €49 billion portfolio of unauthorized equity index futures with fictitious offsetting trades, which was liquidated by the bank at a loss of €6.4 billion; (3) JK's 2007 incentive compensation would have been based on his reported 2007 trading P&L of €25 million, which resulted from €3 million in legitimate gains from his turbo warrant trading plus €22 million in gains generated by his unauthorized trades less €1.475 billion gains from his unauthorized trades concealed by his fictitious trades and provisions (Note: The seven valuation provisions and almost 15 percent of the fictitious trades were entered by JK's trading assistant); (4) the two factors that most contributed to SG's prolonged failure to detect JK's unauthorized and fictitious trading were: (i) ineffective trading management oversight represented by tolerance of intraday trading; disinterest in reconciling JK's profits, margin, and cash movements to his authorized trading activity; indifference to system and counterparty alerts; and, from April 2007, lack of trading oversight experience; and (ii) control procedures that were focused on reporting rather than investigating anomalies, were fragmented among different control groups, and had no triggers for deferred start dates, values, counterparties, trade modifications and cancellations, or mandatory vacation periods; (5) no other evidence was uncovered of similar fraudulent activities in SG's CIB. Note: The report contained no attribution of responsibility to SG's Risk Management, whose role as a second line of defense in managing trading risk was not clearly specified in SG's policies or procedures.

(continued)

484 Implementing Enterprise Risk Management

Exhibit 23.8 (Continued)

Internal/ Date External Description

May21,2008 Internal PwC delivered its diagnostic review of SG's unauthorized trading losses and remedial action plan. PwC endorsed the GIS report's findings and added several more: (1) There were no clear policies or procedures for escalation of queries; (2) trading oversight and control personnel were not trained or instructed to be alert for fraud; (3) trading oversight and control personnel were slow to respond to and lax in resolution of queries; (4) the rigor of DLP's front office oversight diminished as trading volume increased, allowing unauthorized activities such as day trading, P&L smoothing, and position transfers between traders to proliferate; and (5) trading oversight policy omitted to require monitoring of cash movements. PwC also endorsed SG's two-part action plan, consisting of a series of immediate fixes and longer-term structural changes, specifically: (1) immediate strengthening of GEDS's front office supervision across all equities, fixed income, derivatives, and commodities trading desks by means of heightened awareness of responsibilities, along with introduction and use of monitoring tools; (2) immediate strengthening of GEDS's middle and back office controls by means of remedying controls found to be missing or ineffective; (3) immediate strengthening of system access controls and IT security; (4) immediate strengthening of governance by specifying roles, responsibilities, and escalation protocols across all relevant positions; (5) a four-part transformation strategy to improve GEDS's control infrastructure, culture, and IT security, consisting of: (a) more control-sensitive operations processes; (b) creation of a cross-divisional operational surveillance program designed to identify and rectify anomalous situations and chronic conditions that could be symptomatic of or conducive to fraud; (c) long-term IT security improvement plan; (d) professional ethics and accountability education program for traders and their support staff; and (6) formation of two committees tasked with ensuring implementation of these initiatives.

May30,2008 Internal Mustier resigned as CIB head and voluntarily surrendered his bonuses for 2007 and 2008; however, he remained withSG.

June 20, 2008 External The French Banking Commission (Comission Bancaire, CB) interviewed SG officers in the course of investigating JK's unauthorized trading.

July 2, 2008 External JK switched legal counsel to a more aggressive firm.

Exhibit 23.8 (Continued)

Internal/ Date External

July 4, 2008 External

July 11,2008 External Aug, 1,2008 External

Aug. 5,2008 Internal

Sep.7,2008 External Sep. 14--18, External

2008

Sep. 19-29, External 2008

Sep. 2008 Internal

Nov. 3, 2008 Internal

Nov. 1-30, External 2008

Dec. 2008 External

Feb. 18, 2009 Internal

CONTROL COMPLACENCY 485

Description

The CB found that SG violated banking regulations by not having adequate financial controls, and imposed a fine of €4 million, close to its maximum allowable penalty. The CB's key observations were: (1) poor supervision, (2) monitoring staff inattentive to fraud, (3) deficiencies in IT systems, and (4) inadequate limits and policies.

IndyMac Bank placed into receivership. JK's trading assistant was indicted on a relatively minor

charge of complicity. SG announced year-to-date losses and write-downs on

exotic credit derivatives of €789 million. Fannie Mae and Freddie Mac placed into receivership. Merrill Lynch sold to Bank of America, Lehman Brothers

filed for bankruptcy, AIG downgraded and rescued by New York Fed with a U.S.$85 billion borrowing line, money market mutual fund Reserve Primary Fund suffered such catastrophic losses on its asset-backed commercial paper holdings that its net asset value ''broke the buck," and commercial paper market seized up.

U.S.$700 billion "take-it-or-leave-it" Paulson rescue plan voted down by Congress, Washington Mutual seized by FDIC and its banking assets sold to JPMorgan Chase, Wachovia seized by FDIC, and sale of banking assets to Citigroup negotiated.

Mustier appointed CEO of SG's investment management business with €350 billion assets under management.

SG announced a further of €370 million of losses and write-downs on exotic credit derivatives and €754 million of write-downs on its U.S. residential mortgage monoline insurance, provided mainly by AIG.

Fed provided emergency US$ liquidity to foreign banks (most notably Depfa and Dexia), negotiated Troubled Asset Relief Program (TARP) equity stakes in second wave of U.S. banks, rescued Citigroup with another U.S.$20 billion of capital on top of U.S.$25 billion already injected, pledged U.S.$600 billion to buy MBSs guaranteed by Fannie Mae and Freddie Mac.

U.S. economy officially declared in recession since December 2007.

SG announced its full-year 2008 results, which included €792 million losses and write-downs on exotic credit derivatives, €1.0 billion write-downs on its U.S. residential mortgage monoline insurance, and €1.2 billion losses and write-downs on its European asset-backed security (ABS) underwriting and distribution business. These losses were partially offset by €2.2 billion of mark-to-market gains on credit default swaps held for portfolio protection.

(continued)

486

Exhibit 23.8

Date

May2009 May2009

Aug.2009 Aug.2009 2010

May2010

June 8, 2010 Sep.2010 Oct. 5,2010

2011

2012

Oct. 23, 2012 July 4, 2013

Implementing Enterprise Risk Management

(Continued)

Internal/ External

Internal External

External Internal External

External

External External External

External

External

External External

Description

Daniel Bouton ended his tenure as chairman of SG Group. France's economy declared officially in recession since

Q3-08. France's recession officially declared ended Q2-09. Mustier resigned from SG Group. Regulatory and investor lawsuits emerged, aimed at

deceptive residential mortgage securitization practices, flawed mortgage foreclosure practices, and misrepresentation of mortgage borrowers' creditworthiness.

Publication of JK's memoir L'Engrenage: Memoires d'un Trader (The Spiral: Memories of a Trader).

JK's trial commenced. U.S. recession declared officially ended as of June 2009. JK was convicted of the charges, sentenced to five years in

prison with two years suspended, and ordered (symbolically) to repay SG's €4.9 billion in losses. JK filed an appeal and remained free pending its hearing.

Markets became anxious over EU banks' exposure to peripheral EU countries.

U.S. banks able to repurchase TARP stakes with new stock issuance.

JK's appeal denied and his conviction upheld. Paris employment tribunal denied JK's request to void his

dismissal, levy a €4.9 billion fine on SG, and form an inquiry to question the justification of his conviction.

What Actually Happened

Kerviel' s criminal triallasted three weeks, during which the defense attorneys rein- forced Kerviel's claims that his managers at Societe Generale were well aware of the nature and scale of his trading and encouraged him to continue, so long as he made profits. They highlighted that Kerviel did not derive any personal profit from his unauthorized trades. Societe Generale's attorneys, acting as co-plaintiff, acknowledged the failings in supervision and control described in the internal audit and PwC reports published in 2008, but rebutted any suggestion that the bank knowingly allowed Kerviel to conduct the unauthorized trading that resulted in its massive loss. Both parties had to wait another three months for the verdict, which caused a new uproar when it was announced on October 5, 2010. The three- judge panel found Kerviel guilty of all three charges-abuse of trust, forgery, and computer access abuse-and sentenced him to five years in prison with two sus- pended, ordering him to compensate Societe Generale €4.9 billion (U.S.$7.1 bil- lion) for its losses. No penalties or reprimands were directed at Societe Generale at all. Kerviel's attorneys immediately filed an appeal, while the severity of the

CONTROL COMPLACENCY 487

sentence and Societe Generale' s complete exoneration reignited media speculation that France's financial establishment had colluded to label Kerviel as a scapegoat.

Kerviel's appeal took another two years to be heard, but the result did not go in his favor. On October 24, 2012, the appeals judge upheld the trial verdict and sentence. However, Kerviel did not immediately go to jail or pay any of the compensation to Societe Generale, whose amount was clearly symbolic. In fact, he disappeared from public view after the appeal and only briefly reappeared in July 2013, to ask a Paris employment tribunal for his January 2008 dismissal by Societe Generale to be overturned and an independent inquiry constituted to investigate the circumstances surrounding it. However, the tribunal rejected his request, leav- ing Kerviel to seek other options to delay or escape his sentence.

QUESTIONS 1. Could other DLP traders have manipulated GEDS's transaction systems like Kerviel

did? 2. Was it typical for middle office employees to be promoted to the front office? 3. When Kerviel worked in the middle office, did he show any unusual aptitude for

manipulating the transaction systems? 4. Did DLP have any rules or disincentives designed to deter traders like Kerviel from

undertaking unauthorized trading? 5. Why did Kerviel make such huge bets when he did not derive any personal benefit

from the profits? 6. Had there been any previous instances or notifications of deficiencies in DLP's controls? 7. Was Societe Generale prudent in assigning sole responsibility for market risk oversight

to trading management? 8. Did GEDS make effective use of market risk management? 9. Why did financial reporting catch the fraud, not trading management, operations, or

risk management? 10. Had there been any previous instances or notifications of deficiencies in DLP's transac-

tion systems? 11. Why did operations employees fail to validate the explanations or escalate any of the

many queries relating to Kerviel's unauthorized trades? 12. Did Societe Generale omit any information at the trial that might have exonerated

Kerviel? 13. Did the Paris prosecutor have sufficient grounds for criminal charges against Kerviel? 14. Did Societe Generale sufficiently admit its responsibility for the losses? 15. Was Societe Generale so focused on achieving growth on many fronts that it neglected

to invest in sufficiently robust systems and internal controls?

REFERENCES MarketWatch. 2008. "Text of Daniel Bouton's Letter to Customers and Shareholders

Disclosing Societe Generale's Trading Losses." January 24. www.marketwatch .com/ story /letter-from-societe-general-ceo-to-customers-and-shareholders.

Societe Generale. 2008. "General Inspection Department 'Mission Green' Summary Report." May 20. www.societegenerale.com/sites/default/files/documents/Green_ V A.pdf.

Societe Generale. 2008. "Report of the Special Board Committee Investigating the Trading Losses." May 23. www.societegenerale.com/sites/default/files/documents/ rapportcomitespecialmai2008.pdf.

488 Implementing Enterprise Risk Management

PricewaterhouseCoopers. 2008. "Summary of Diagnostic Review and Analysis of the Action Plan." May 23. www.societegenerale.com/sites/default/files/documents/ pricewatercooper .pdf.

Societe Generale. "Annual Reports 1999-2007." www.investor.socgen.com/phoenix.zhtml? c=69575&p=irol-results.

Kerviel, Jerome. 2010. L'engrenage: Memoires d'un trader (The Spiral: Memories of a Trader). Paris: Flammarion; pap. ed., J' Ai Lu, 2011.

ABOUT THE CONTRIBUTOR Steve Lindo is a financial risk manager with more than 30 years' experience man- aging risks in asset/liability management (ALM), funding, international fixed income, and alternative asset portfolios. His current role is Principal of SRL Advi- sory Services, an independent consulting firm specializing in risk governance, cul- ture and education, risk strategy, measurement, and regulatory expertise, in the United States and internationally. His career includes U.S. and international risk management positions with Fifth Third Bancorp, GMAC Financial Services (now Ally Financial), Cargill Inc.'s proprietary financial trading group (today operating as Black River Investments and Carval Investors), First National Bank of Chicago (now part of JPMorgan Chase), and Lloyds TSB Bank. During 2008-2010, he under- took a two-year engagement as CEO of the Professional Risk Managers' Inter- national Association (PRMIA), a nonprofit member organization with more than 75,000 members in 198 countries. He has a BA and an MA from Oxford University and speaks fluent French, German, Spanish, and Portuguese.

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