The Hindu Business Line : The missing red flag

Legends tend to get replaced sooner rather than later in all walks of life. If Bjorn Borg was replaced by Roger Federer, Nick Leeson has been replaced by Jerome Kerviel of Societe General, a large bank. Apparently, the bank has incurred a loss of €4.9 billion on trading positions taken by him. Nick Leeson was successful in bringing down the Barings Bank.

Striking similarity

The similarities between these two “rogue traders” are too striking — both were employed in the back office before being promoted to trading position and they misused their knowledge of back-office operations to ensure that they did not get noticed. What appears more surprising in the Societe General case is that the trader never made any money on this — a sort of harmless guilt.

This has brought back to the fore questions on the risk management strategy employed by banks and the role of accounting and finance to detect such gross misdemeanours. Already there are rumours of many employees leaving the bank and the bank being a prime target for a takeover — proof of the damage that can be caused by a trader who had a bad day at the office and decided to remain silent about it.

What the trader did was to use equity derivatives in a billion euro gamble that Europe’s leading stock exchanges would rise. He bet on futures contracts on indices such as the FTSE 100, Euro Stoxx 50, Germany’s Xetra Dax and the French CAC40. These were essentially agreements to buy and sell an index in the future, thereby winning if the indices rise above the spot and losing if they don’t. While the Xetra Dax, which the trader was heavily exposed to, fell by 15 per cent since his deal, the FTSE 100 futures have fallen 10 per cent.

Bean-counters blamed

Risk management experts pin the blame on the accounting and finance departments. The derivatives department could have assessed the positions taken by the trader but the accounting and finance departments had failed to verify whether these positions were wholly genuine. One red flag that the bean counters could have detected was the failure of some hedges to settle. Apparently, this was given a go-by given the huge backlog of unsettled derivative trades in equity and credit securities. It is also a fact that the accounting and finance functions would have thought nothing amiss since similar positions in the past could have given rise to stellar profits for the bank later. It is also a fact that the bank was such a big trader in the market that a large exposed position could have been considered to be small fry in their global balance-sheet.

The question that everyone appears to be asking is: Why haven’t the lessons of the Barings fiasco been learnt? Such large banks ought to be making reconciliations at least twice a day with the exchanges and clearing houses. A $1 billion in mark-to-movement is not a thing to be passed off lightly irrespective of the size of the entity.

Regulatory bodies are asking for tighter supervision of existing procedures although none has suspected the internal controls at Societe General, which were stated to be robust. Senior officials at the bank should be crying hoarse “it’s the technology stupid” since the trader in question apparently logged on and off the trading platform using other employees’ passwords, thanks to his days at the back office.

(The author is a Hyderabad-based chartered accountant.)

Real-time audit

The Sarbanes Oxley Act has a concept called “walkthroughs” which encourages one to walk through a transaction from origination to culmination with a view to detect loose internal controls. While this could check systemic deficiencies, the need of the hour is “real-time” audit that can detect a potential loss the moment it makes its way into the books of account. But there could be no ideal solution for a real-time audit.

Maybe a combination of more rigorous trading controls and the age-old audit concept of “exception reporting” — which raises a red flag the moment a particular transaction crosses a particular benchmark — could minimise such losses if not prevent them. One can expect more rigorous standards and disclosures in IFRS-7 (Financial Instruments – Disclosures).

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