Managerial Economics & Organizational Architecture 6th Edition by James Brickley , Clifford Smith ,Jerold Zimmerman

Exercise 3

ANALYZING MANAGERIAL DECISIONS: Société Générale
Société Générale was founded in the 1860s and in 2013 was France's third largest bank. Beginning in the mid-1980s, it pioneered some of the most complex instruments in international finance and became a global powerhouse in trading derivatives like futures and options. Through its trading activities, the bank earned billions of dollars and gained the respect of bankers throughout the world. In January 2008. Risk, a monthly magazine about risk management, named Société Générale its "Equity Derivatives House of the Year."
In late January' 2008. Société Générale announced that it had discovered fraudulent securities trading by one of its low-level traders, Jérôme Kerviel. The bank reported that it expected the fraud to cost it a staggering $7.14 billion, making it one of the largest financial frauds in history. The announcement shocked the financial markets and made front-page headlines around the world. Observers questioned whether the bank could ever regain its former reputation and whether it could continue to exist without merging with another bank.
Société's CEO Daniel Bouton asserted that the fraud was the result of one employee's illegal activities, did not involve other employees at the bank, and represented the aberrant and unexplainable actions of one "rogue trader." He characterized Kernel's actions as "irrational" since the trades were made on behalf of the bank "netting the trader no personal gains." Bouton emphasized that Kerviel was a low-level employee who had an annual salary and bonus for 2007 of less than $145,700.
In principle Kerviel engaged in a quite simple operation: arbitrage-trading on small differences between various stock market indexes such as the CAC in France and the DAX in Germany. Kerviel should have been able to lock in a virtually riskless profit by selling a security on the exchange with the higher price, while simultaneously buying an equivalent instrument on the exchange with the lower price. And although price differences are typically small, such arbitrage can produce a substantial profit if done in sufficient volume. In this arbitrage business, although Société Générale might accumulate large positions on both exchanges, those securities that it bought and those it sold should balance. The bank was supposed to face little net exposure to price changes.
What the bank discovered was that Kerviel had bought securities on both markets. In effect, he had made enormous bets that European stock prices would increase. But they had fallen, and as a result the bank incurred a substantial loss.
The subsequent investigation revealed that Kerviel had been placing huge unhedged bets on European stocks for over a year. Prior to becoming a trader he had worked in the bank's trading accounting office. His knowledge of the bank's risk-management system allowed him to conceal the trades and bypass the firm's control system. He knew the timing of the nightly reconciliation of the day's trades and would delete and then re enter his unauthorized transactions without being caught. Bank managers, however, had apparently dismissed several warning signs about Kernel's transactions. For example, the surveillance office at Eurex, one of Europe's biggest exchanges, alerted a compliance officer at the bank that for seven months a trader named Kerviel had engaged in "several transactions" that raised red flags. Kernel's supervisors accepted his explanations for these trades apparently without much investigation.
Various bank officials, investigators, and traders who worked with Kerviel have concluded that Société Générale "allowed a culture of risk to flourish. creating major flaws in its operations" that enabled Kernel's actions to proceed. Several current and former employees interviewed by the New York Times, indicated that Société Générale traders were rewarded for making risky investments with the bank's money and that it was not uncommon for traders briefly to exceed limits imposed on their trading, despite controls meant to prohibit this activity. Risk taking apparently was "embraced, as long as it made money for the bank." Top executives and other managers at the bank had received large bonuses because of the bank's successful trading operations.
Kernel told investigators that all he wanted was to be respected and to earn a large bonus. He had come from a modest background and did not have the educational pedigree of many of his coworkers who had advanced degrees in math or engineering from the prestigious Grandes Ecoles-the MITs of France. He was noted for working very long hours and had worked his way up in the bank from being a clerk to a trader. One of his primary goals was to have his supervisors recognize his "financial genius."
Discuss how the bank's organizational architecture contributed to the problem.
Source: This application is based on a series of articles from the New York Times published in early 2008. In particular see N. D. Schwartz and K. Bennhold, 2008, "A Trader's Secrets, a Bank's Missteps," nytimes.com (February 5).