Reports highlight SG weaknesses

Two reports investigating the EUR4.9 billion losses suffered by Société Générale in January, the result of fictitious and unauthorised trades allegedly conducted by Jerome Kerviel, were released on May 23. And the findings of the reviews, conducted by PricewaterhouseCoopers (PWC) and the bank's own general inspection department, will not have made comfortable reading for SG's senior management.

According to the PWC report, there was a "mismatch between the resources allocated to support and control functions and the level of front office activities", at a time of rising trading volumes in the equities division.

This point was echoed in the general inspection team's analysis, which said the failure to detect Kerviel's unauthorised activities - dating back to 2005 - revealed serious weaknesses in supervision and controls over market activities.

Specifically, Kerviel's immediate supervisor lacked trading experience and "demonstrated an inappropriate degree of tolerance in relation to the taking of intra-day directional positions. Neither he, nor his own supervisor, carried out an adequate review of the trader's activities on the basis of the available figures and reports, or reacted to alerts that would have allowed them to identify the concealed positions."

The report also alluded to a fragmentation of controls between business units and an insufficiently precise division of tasks, which led to Kerviel's actions not being escalated to the appropriate levels of management.

The inspection department confirmed that Kerviel adopted three major concealment techniques. The report cited 947 transactions where he entered one or multiple false trades in the bank's systems but was able to set parameters that covered fraudulent positions taken elsewhere, 115 examples where he entered pairs of fictitious reverse transactions, and nine occasions involving the booking of intra-month provisions to temporarily cancel latent or realised earnings.

Intriguingly, the bank claimed to have "discovered indications of internal collusion involving a trading assistant, a middle-office operational agent", who registered 15% of Kerviel's fictitious trades. SG has been unable to question the agent due to the ongoing criminal investigation into the case.

Nevertheless, the report did reveal the causes for the bank's suspicion, the most notable of which involved the assistant registering several abnormally high intra-month provision flows, which allowed Kerviel to conceal earnings generated by fraudulent positions. Generally, the inspection department said, provision flows are limited to several hundred thousand euros. However, the assistant made seven provisions of more than EUR50 million in 2007 and 2008, and one provision (on January 10, 2008) of EUR1.5 billion, which the bank claims allowed Kerviel to cover up earnings generated in 2007.

In the wake of the rogue trading scandal, SG has embarked on an extensive programme to address weaknesses in internal controls, an initiative that will see more than EUR100 million invested over the next two years. Among the measures already implemented, which are applicable across all business groups, are controls and limits on the nominal value of positions, a reintroduction of the review of nominal values into the analysis of daily earnings, and the reinforcement of processes for trade confirmations with deferred start dates and for those involving internal counterparties (Risk April 2007, pages 28-29).1

More broadly, the bank will introduce structural reforms designed to manage and prevent operational risk, including a product control model to reinforce integration and cross-departmental co-operation of key procedures linked to processing and accounting. The bank will also create a new group responsible for trading security, including a team devoted to fraud prevention. As well as investing in new information technology systems, SG says it will also launch a campaign to raise staff consciousness, and set out more formalised definitions of roles and responsibilities.

"The capacity of the information technology department to respond to all of the demands will be a determining factor in the programme's success," stated SG. "More generally, the bank must mobilise high levels of expert human resources in numerous support and control positions. Further, the complete success of the programme relies on the capacity of SG and of the central control services to propagate amongst all employees a culture of responsibility, discipline and mutual respect."

As well as employing PWC to conduct the external investigation, SG will use the advisory firm to monitor the bank's progress on implementing reforms until mid-2009. And PWC pulled no punches in analysing the bank's initial efforts to prevent future trading scandals, describing its progress as "mixed".

One area of concern surrounds SG's controls over the nominal size of transactions, which PWC says are still not operating properly across the company, in particular within the fixed-income and equities groups. Additionally, controls at operating-group level for initial margin requirements and margin calls for listed futures have not been implemented due to technical problems, while the ability to highlight modified or cancelled trades has not yet been extended to all fixed-income deals.

PWC's report also states audit trails for the confirmation of trades involving internal counterparties needs to be improved, while noting that there are still some exceptions to password protection for sensitive computer applications.

Rob Davies.

See also:

• SG moves on

• Genius or blunder?