Sunday, May 25, 2008

Watch the Winners: a Lesson from Societe Generale

Societe Generale, Societe Generale,

Dormez vous, dormez vous?

Sonnez les alarmes, sonnez les alarmes.

Din, dan, don. Din, dan, don.

A report from an internal investigation conducted by Societe Generale into its $7.7 billion loss from the activities of its trader, Jerome Kerviel, recently revealed that an assistant trader may have helped Kerviel. The level of this assistant's involvement remains unclear. And even though the bank maintains that no one knew what Kerviel was up to, executives in his chain of command have been leaving the bank, or are in the process of departing. Societe Generale's initial explanation that the entire loss was the result of Kerviel acting alone and without anyone's knowledge may or may not be accurate. But it is unquestionably pathetic.

SocGen's trading scandal illustrates a basic oversight failure: not watching its winners. Sound management goes beyond keeping an eye on the weak performers and other obvious potential sources of problems. You have to evaluate your success stories. How are they generating such great returns? How did they go from being average or below average performers to such stars? Was it brilliance that no one spotted, or unacceptable risk taking that no one detected?

Kerviel was engaged in proprietary trading for SocGen. Big profits from proprietary trading involve big risks. It's not a volume business. The Jerome Kerviels of the world don't make a billion dollars by selling 100 million Big Macs. They make a billion dollars by going way out on a limb. Apparently, Kerviel made some sizeable profits for SocGen in 2007. Surely management noticed his profits, and one suspects that the entire chain of command was eager to share in the credit (as well as the bonuses). But how could they explain outsized performance by a low level trader such as Kerviel, who supposedly was limited to hedged positions that should generate modest, if reliable, profits? There's no such thing as a gift horse when proprietary trading profits are concerned. Big profits mean that someone somewhere took some big risks. It's management's job to figure out where that happened and whether or not it was authorized and acceptable.

It may seem to cut against a business corporation's cultural grain to question success. Making money is what corporations are supposed to do. But corporations use other people's money, namely the shareholders' money. It's management's responsibility to ensure prudent and authorized use of that money. This responsibility is only magnified when a major international bank like SocGen is concerned. A failure of a bank such as this could have repercussions worldwide. Like or not, we all have a stake in SocGen and other financial institutions of its stature. Regulators should ensure that money center banks and other major financial institutions watch their winners.

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