Last Updated 28 Jan 2021

Jerome Kerviel – Genius of Fraud

Category Banking, Finance
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Imagine growing up in a working class European family that is getting by but is by no means rick. You've done well in undergraduate college and are on the verge of graduating with a Masters in Finance from a reputable university but didn't do much to differentiate yourself while there. After grad school, you receive an offer for a middle office position at a large investment bank who guaranteed there's room to grow into a trading position, you're ultimate dream. You've finally made the move onto the desk and are doing well but again, haven't distinguished yourself enough to get that immense bonus. And you think to yourself, what can I do to impress my bosses? That, in a nutshell, describes Jerome Kerviel.

Jerome Kerviel grew up in Pont-l'Abbé, Brittany in Northwestern France to a hairdresser and blacksmith. He received a bachelor's degree in Finance from the University of Nantes, later attending University Lyon 2 to pursue a Master in Finance where he graduated in 2000 with a specialization in organization and control of financial markets. According to a source at Lyon, there was nothing remarkable about him. He was a student like everyone else but didn't distinguish himself in any way.

Kerviel began at Societe General in the middle office after receiving his Master's degree. He initially began in the compliance department and was promoted to the Delta One products team in 2005 as a junior trader. This area of the bank dealt with program trading, exchange traded funds, swaps, index and quantitative trading. He did well at the bank but again didn't set himself apart and wasn't considered a star. In 2006, he received a salary of EUR 74,000 with a bonus of EUR 60,000 hoping that in 2007, based on his performance, that bonus could be upwards of EUR 300,000.

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In early 2006, Kerviel began creating fictitious trades that were initially relatively small. As time progressed, the fake trading increased in both frequency and size. At the end of 2007, the trader had shown a massive profit of EUR 1.4 billion in unauthorized trading. When the Bank discovered the unauthorized trading January 19, 2008, Kerviel had built a book of unauthorized opens positions which at that point amounted to a notional value of around EUR 50 billion. The Bank began unwinding the positions on January 21, 2008 and over three days of trading was able to close all of the trades. During this time the equities markets dropped significantly and the unwinding of his book led to a loss of around EUR 4.7 billion. By the end of December he was "massively in the money" but since the beginning of 2008, those trades had become unprofitable. Kerviel has claimed that his boss turned a blind eye to what he was doing and encouraged his activity so long as it was profitable. Since he showed such high profits at the end of 2007, his superiors were in support of his actions, however, the moment they turned the other way, it was his name on the line.

According to Societe Generale, "intimate and perverse" knowledge of the bank's controls allowed him to avoid detection. Knowledge of back-office computer functions enabled him to conceal some of his bets by offsetting deals with fictional counterparties. Kerviel would normally close the trades after only a couple of days so as not to be noticed by the bank's internal control system and would then move the older positions to new trades. Bank of France Governor Christian Noyer described him as a "genius of fraud." There was significant deficiency in internal controls, unauthorized trading activities, computer hacking and the breach of trust involving a conscious effort by the rogue trader to deceive his managers. Verdict:

Kerviel was convicted on all charges of forgery, fictitious transactions and falsifying documents to justify his actions, hacking into the bank’s computer to input falsified information and breach of trust concerning the properties of third party (taking positions that exceeded his trading limits). He was sentenced to three years in prison, ordered to repay EUR 4.9 billion in restitution to the bank and barred for life working in financial services. A spokeswoman for Societe Generale said the EUR 4.9 billion award was a "symbolic" sum that the bank did not expect to be paid but it recognizes that the entirety of the losses are attributed to Jerome Kerviel’s actions.

The bank, however, was not absolved of responsibility. A line from the ruling reads: “The lack of vigilance by the bank in monitoring the only existing limits, acting as alert signs, hardly exempted Jérôme Kerviel from his duty to inform his hierarchy of the reality of his excesses or to come back within the limits imposed.”

In this case, the prosecution had the ability to prove each one of the charges. Breach of trust is defined as any act which is in violation of the duties or a trustee or of the terms of a trust and while breach need not be intentional or with malice, it can be due to negligence. In this case, Kerviel breached this trust when he traded past his trading limits. While it was an intentional violation of their trading policies, he did not do this out of disdain for the bank but out of the sheer excitement of trading those types of volumes.

Forgery is the process of making, adapting, or imitating documents (or other objects) with the intent to deceive. This encompasses all of the charges related to forgery that Kerviel was convicted under including fictitious transactions and falsifying documents. Kerviel would forge trading documents in order to submit something to his compliance department, the group monitoring the trading, knowing full well that the trades never took place.

There are few defenses, if any, with regards to Kerviel's actions as they are all documented in the Soc Gen computer system and file cabinets. The one argument that can be made is that while Kerviel took these actions, his superiors knew that they were taking place but did nothing to stop the trading from happening so long as it was profitable. This was Kerviel's initial claim that yes, he entered the trades, but his bosses saw the profitable ones and allowed him to continue trading as he did. One could also argue that even if his superiors weren't aware of the unauthorized trading, Soc Gen's internal risk management policies and procedures failed miserably and need to be revamped. There is no way that a middle office, compliance or risk department should miss trades of that volume and the trading patterns of their employees.

In the U.S., Kerviel could have also been charged with fraud. The French courts, however, decided not to charge him with this more serious allegation. In the U.S., there are five requirements in a fraud case, i) a false representation; ii) of a fact; iii) that is material; iv) that is made with knowledge of its falsity and with intention to deceive, and; v) that creates harm to the victim. In this case, the victim would be Societe Generale and its stockholders as Kerviel caused such immense losses to affect earnings and stock price. He has achieved all five requirements in a U.S. fraud case. He has made a false representation of a material fact (fake trades). He knew the trades were false (as he never made them) and the point of the representation was to deceive Soc Gen in thinking that he was hedging his outstanding positions. In this case, however, he did not make the representation in a way that was intentionally harmful to the company, but the acts he performed did in fact harm the company. He most likely would have been convicted of fraud based on the five requirements in a U.S fraud case; however, he also would have been convicted of forgery, false statements and breach of trust.

Other Cases: Jerome Kerviel was not the first person to game the system and find ways around its trading restrictions. Societe Generale joins a list of at least five financial firms since the start of the 1990s to suffer losses from unauthorized trades, including Kidder Peabody, Barings, Credit Agriocole, and Allied Irish Banks Plc.

In 2007, Credit Agricole SA said an unauthorized proprietary trade at its investment-banking unit in New York cost the company EUR 250 million. Barings Bank was the oldest merchant bank in London until its collapse in 1995 after one of the bank's employees, Nick Leeson, lost £827 million ($1.3 billion) due to speculative investing, primarily in futures contracts, at the bank's Singapore office.

In 1994, Kidder Peabody, then owned by General Electric Co., took a $210 million charge against first-quarter earnings to reflect what it said were false profits recorded by bond trader Joseph Jett. The allegations and unrelated bond losses led GE to sell most of Kidder to Paine Webber in 1995 which was purchased by UBS AG in 2000.

Sumitomo Corp. disclosed a $2.6 billion loss in 1996 on copper trades that the firm blamed on unauthorized trades by its chief copper trader, Yasuo Hamanaka, who was known as ``Mr. Copper'' in the markets because of his aggressive trading. Hamanaka was sentenced to eight years in prison in 1998.

Allied Irish Banks Plc discovered in 2002 that John Rusnak, a trader at its Allfirst Financial Inc., had amassed and hidden $691 million of losses over more than five years before the company noticed any discrepancies. Rusnak was sentenced to 7 1/2 years in prison. Allied Irish sold the Baltimore-based unit to M&T Bank Corp.

Present Day: According to the President of the Federal Reserve Bank of New York, "a successful risk management system should satisfy at least four basic principles: 1) it should be subject to active oversight by the board of directors and senior management of the financial institution; 2) it should embody well-conceived risk identification measurement and reporting system; 3) it should include comprehensive internal controls emphasizing the clear separation of duties; and 4) it should incorporate a well-defined structure of limits on risk taking." A review of Soc Gen's risk management systems showed a significant failure in the design in one or more of these principles at the time of Kerviel trading.

Axel Pierron, a senior analyst at Celent, an international financial research firm, feels differently about risk and writes "Banks, despite the implementation of sophisticated risk management solutions, are still under the threat that an employee with a good understanding of the risk management processes can get round them to hide his losses."

Societe Generale spent EUR 130 million in 2008 and 2009 as part of a three-year plan to enhance risk controls, with more than 200 people working on the project. Their fraud control-team continues to search for signs that may hide another Jerome Kerviel. The Bank now has about 80 different alerts built into the bank's proprietary security system that can be triggered by a trader. These include exceeding a euro trading limit, deferring a transaction date or failing to take vacation. This is behavior that Kerviel displayed as he tried to cover wrong-way bets on the direction of the stock market. The bank has now introduced specific controls to guard against what Kerviel did and takes a different strategy towards growth in the firm; "growth with lower risk."

While Kerviel is not the first person to put a company in jeopardy due to a tremendous disregard for risk and internal policy, a situation like this truly exemplifies the Wall Street mentality. Traders on Wall Street have it ingrained in their mind that making money is the most important thing, regardless of the moral or legal implications of their actions. In his book, Kerviel wrote, "I had taken too much of a risk, my trading positions were too big. I had succumbed to the intoxication of the numbers game and to the excitement of my job and there were no safeguards to rein me in." He has previously stated that making enormous profits gave him "orgasmic pleasure." He loved the numbers, the excitement, the profits and the lack of internal and regulatory oversight that leads to situations like these. He didn't care that he was breaking internal policy so long as he could get the thrill of a huge profit. He didn't realize the severity of his actions until it was proven he had broken the law.

Jerome Kerviel – Genius of Fraud essay

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