Thursday, October 7, 2010

Jerome Kerviel is sentenced: Ruminations on risk and trading scandals

A French court has sentenced Jerome Kerviel, the SocGen trader who caused the company to lose 5 billion Euros, to five years in prison and a fine of 4.9 billion Euros.
I think we can safely assume that Mr. Kerviel is now bankrupt for life. Reading about the case did raise a question in my mind. How can one person cause this much damage and how did the damage remain undetected until too late? I know that people have pointed to the asymmetric reward structure (where huge bonuses are paid if you make large profits and you really don't share in the losses) at banks as a culprit, but I think there are three "behavioral" factors that contribute to disasters such as this one.

1. Selection bias: Experimental economists have been exploring differences in risk aversion across sub-groups of people and their conclusions are fairly strong. For the most part, their studies find that younger people tend to be less risk averse than older people, single people are less risk averse than married folks and men are less risk averse than women (especially young). Now think about your typical trading room in any investment bank. It is over populated with 25-35 year old males, selected primarily because they had the right "trading" instincts. In fact, I think you can safely assume that if you were picking the least risk averse group in a population, it would look a lot like that trading room.

2. House money effect: You tend to be much less careful when taking risks with "house" money than with your own. Traders almost always are playing with house money, especially when they are doing proprietary trading, and not surprisingly are more cavalier about taking risk than they would be with their own money.

3. Break even effect: Here is a phenomenon that every casino owner knows. When a gambler loses money, he tries to make it back, and the deeper he gets in the hole, the rasher he becomes in his risk taking. So, a trader who loses $ 100 million will try to win it back with big bets (even if those bets don't make much economic sense); the more he loses, the wilder his risk taking will become.

One of the problems with the risk management systems that we have is that they deal with the symptoms and not the causes of erratic and bad risk taking. If we want to reduce the likelihood of more Jerome Kerviels in the future, here are some things we should do:

a. Create more diverse trading rooms: I am not a fan of diversity for the sake of diversity, but I think that opening up trading rooms to a wider range of people will dampen some of the excess risk taking. Maybe we should hire every trader's mother or grandmother to trade side by side with him; in fact, I would give her the next desk. Seriously, though, this will require investment banks to revamp their hiring processes and look more kindly on those "not cool" kids on campus who right now would not make the cut.

b. Restrict or eliminate proprietary trading: I know that proprietary trading is viewed as too lucrative to let go by banks, but I have my doubts as to whether it actually generates long term profits for any of its architects. One side cost of the increase in proprietary trading at banks has been the increase in house money that traders have to play with.

c. Information systems: To stop the "break even" effect from kicking in, we have to intervene much earlier when traders start losing money to prevent them from accelerating the cycle. To intervene, we need to know how much traders are making or losing in real time and have automated or computerized systems step in and stop trading at a defined loss point. Traders will try to devise ways around the system, but the system has to be responsive enough to adapt.


funindra said...

I think rather than the behavioral factors it is the lack of adequate internal control systems as the reason. There were enough examples for us to learn from even before Jerome Kerviel of Société Générale bank. we had the case of Daiwa bank in 1995, wherein the head of securities trading was fraudulently hiding the losses. which resulted to a total loss of $1.1 Billion and also a similar debacle of The sumitomo corporation in 1996. Here too a copper trader started playing with derivatives on LME and lost, which also resulted in a accounting loss of $1.8 billion.

Time and again these things seems to surface and for the same reason "lack of adequate internal controls".

The fact that the trader(at Société Générale bank) has been hiding things from the superior of this magnitude clearly indicates a lapse of internal control . Which the bank indirectly seems to admit in court. So are there any even more bigger problems or losses yet to unlock at Société Générale ??

Fixing the internal control systems is the need of the hour.

Traders have different psychologies. so i don't think there can be one point or two point solution to behavioral issues. And they are never constant but change along with time. Fixing this through addressing behavioral issues might be costly as well.

The better way is to put a control system in place, start monitoring and testing the system regularly. so next time nothing goes undetected and unreported. Even a risk management system fails in the absence of a internal control system.

so which one do you think is the better way to fix these type of problems? addressing the behavioral issues ? or rather putting control system in place?

Unknown said...

Prof, i think Jerome Kerviel is being made scapegoat. The whole story seems like a fairy tale... I totally agree with the third point of break-even effect, Nick Leeson (Rouge Trader) was also was in similar situation of covering/hiding losses ending up in blowing up the entire bank... As far as diverse trading room is concerned, trading gets more exciting with high adrenaline of young traders...

doctorgeeta said...

In India, some "enterpreneurs (authorised traders" have rented-out/ given trading terminals to some young hot-shots "day-traders" with a daily limit and margin money;

profits are shared/ divided on the basis of individual investments and close controls are kept on trades/ profits/ losses.

It is a "win-win" situation, unlike developed economies where too much of trust and authority is vested in individuals with plain greed dictating decision making.

perpetual wonderer said...

I think in addition to factors you have identified, there is also the ego that fancy business school grads are made to have. They are pitted against each other and at some point, playing it sane is considered humiliating. Unless you sniff out a killer deal or design a super exotic product or something of the sort, you are not worth your salt. That may have a big role in deals that don't make economic sense falling through. Don't know if this was material in the Societe Generale case, but I know it is at play somewhere. It may be a concept primarily falling in psychology, but I think it has a big role to play in behavioral finance too.

Aswath Damodaran said...

Most traders are not MBAs. The traders at a few elite investment banks may be, but even in the top investment banks, many traders made it through the ranks. So, I think it may be easy to blame a business school education for risk taking behavior, but it would be missing the target.

Zurgl said...
This comment has been removed by the author.
Zurgl said...

Here in France, common wisdom seems to be that Jérôme Kerviel had a kind of status complex. In other words, not having the right diploma (remember that he came from the back office!), he grew resentful of traders who enjoyed a more favorable path. Hence a maybe excessive motivation to prove something … I don’t know if this story is 100% true, but if true, it might prove something against diversity: lets populate trading desk with entitled young men who have nothing to prove and whose lifestyle is already guaranteed!

VIKRAM said...

Well said Proffessor, I would like to add one more point. Each trader is burdened with daily revenue targets. On an avg every trader will have 10 to 12 times of his compensation as revenue target.

I do my bit in cautioning the small investor using my blog

perpetual wonderer said...

@Prof: Maybe most traders aren't MBAs. I was not blaming business school education at all, though. I was generally pointing towards the overly competitive pressure conditions and glorified self images that lead to the belief that others have to be outperformed at any cost if you are any good. This is not limited to the financial sector, obviously, but it is much more dangerous there, from a systemic implications perspective. I have seen first hand in my organization, though we are not an investment bank, how an obsession with 'pushing the bar' can have catastrophic results.

maxbonacchi said...

Inside Job seems to offer some anecdotal evidences to your point.

Since the next time