France's second biggest bank, Societe Generale, is reeling from the discovery of a $7.14 billion fraud committed in 2007 and 2008 by Jerome Kerviel, a trader working on the futures desk at the bank's headquarters in Paris. So how did such massive fraud happen and lie undetected for so long?Axel Pierron, senior analyst at Celent, points out that the trader knew very well how to circumvent the bank's risk management system, since he had worked in the back and middle office between 2000 and 2005 before becoming a trader. "I believe he had restrictions, and strict risk exposure as he was a very junior trader. But as he knew the system, he knew how to avoid his transactions being seen," Pierron says.
"No risk management system is 100 percent reliable," he adds. "There are always back door grey areas where you can manage your transactions without triggering monitoring activities."
Kerviel probably started taking unusually high trading positions as a game, with a view to a bigger end-of-year bonus or a promotion, Pierron suggests.
When the financial markets were up, he probably made profits. But when the markets tanked last August, he started making huge losses. He hid his losses and continued to trade in an effort to recover his losses.
Meanwhile, Kerviel's superiors at Societe' Generale may have been focusing so much on their sub-prime losses that they failed to detect the rogue trader's activities, the analyst suggests. (The bank has announced an additional €2.05 billion write down in assets related to subprime exposure)
Soc Gen eventually discovered Kerviel's losses on January 19.
The incident draws comparisons with the fraud that brought down British bank Barings after Nick Leeson lost around $1.38 billion on Asian futures markets. Meanwhile, the SEC recently reported a rise in fraud and other instances of market abuse. So what can banks do to avoid future incidents?
"You can always raise the level of difficulty for a trader to operate," say Celent's Pierron. Nick Leeson was able to carry out his fraudulent activities "very easily." For Kerviel, it was more complex -- but there will always be an incentive for a rogue trader to take advantage of a situation, Pierron points out.
Still, it is essential for there to be clear segregation between the back and middle office and the front office. "How did someone who knew how the back office system work, become a trader?" Pierron asks.
Meanwhile, volatile market conditions increase the likeliness for something like this to happen.
"When conditions are more favorable, traders can hide losses by compensating for them in the market. But when the market is down there is nowhere to hide it," he adds.
Which Pierron says, begs the question, "how much fraudulent activity remains hidden when the markets are favorable and traders can hide their losses?"France's second biggest bank, Societe Generale, is reeling under the discovery of a $7.14 fraud committed by Jerome Kerviel, a trader working on the futures desk at the bank's headquarters in Paris. So how did such massive fraud happen and lie undetected for so long? Melanie Rodier has worked as a print and broadcast journalist for over 10 years, covering business and finance, general news, and film trade news. Prior to joining Wall Street & Technology in April 2007, Melanie lived in Paris, where she worked for the International Herald ... View Full Bio