Jeremy Warner's Outlook: A crisis entirely of SocGen's own making

Markets enter overshoot territory; Dangerous dogs threaten regulation
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The Independent Online

"There but for the grace of god ..." has been the response of many bankers to news of financial wipeout at Société Générale as a result of the antics of the rogue trader Jérôme Kerviel. Yet having viewed the available evidence, I'm sticking to my original view that this is much more a case of incompetence than bad luck.

The detailed explanation proferred by SocGen over the weekend of how M. Kerviel managed to execute his trades without anyone noticing is completely unconvincing, as is the excuse that M. Kerviel managed to persuade his superiors that all his positions were hedged and therefore incapable of making serious losses.

Anyone with half a brain given the detailed knowledge of trading positions that must have been available internally at SocGen could have worked out that the situation at least merited some further investigation. It now transpires that SocGen was warned as early as November by Eurex, the derivatives exchange, about the positions being taken by the 31-year-old trader, but chose to do nothing about it after M. Kerviel produced a fake document to demonstrate that his risk had been covered by hedging.

Traders dealing in index futures say that M. Kerviel's name was very familiar to them from long before the balloon went up because of the size of the positions he was taking. Quite a few of them, sensing a wrong'un, refused to deal with him. Yet still SocGen managed to keep its head buried in the sand.

SocGen professes to be mystified as to M. Kerviel's motivation, since he wasn't in any way incentivised through the bonus structure to take massive risks with the bank's money. If by any chance his gambles had paid off, all the profits would have gone to the bank, and not to M. Kerviel.

Yet in truth there is no great mystery here. M. Kerviel strayed way beyond his authority first because he was almost certainly completely bonkers, but, much more importantly, because he could. The bank's controls were so lacking that M. Kerviel could easily circumnavigate them and plainly drew some satisfaction from so doing. There is no reason to disbelieve his testimony yesterday that straying beyond your trading authority was endemic at SocGen, with a number of previous, though obviously less painful, instances of it.

Having failed to spot M. Kerviel's miscreant behaviour, SocGen then compounded its mistake and its losses by ineptly attempting to liquidate the positions into a falling market.

The bank's legal advice would have been that with a trading update imminent, it had no option but to unwind M. Kerviel's trades. Bizarrely, the bank seems still to be taking some pride in the "professionalism" with which this exercise in asset destruction was conducted, gradually, so as not to disrupt the market.

To outsiders, it nonetheless looked like a massive shorting operation and cannot help but to have contributed to the rout in European equity markets that took place on Monday and Tuesday last week. Had SocGen piled all its capital into a heap and set it alight, it could scarcely have handled the situation more destructively.

Fundamentally, what banking is meant to be about is raising money from depositors and lending it on to creditworthy borrowers. Once you start getting into arbitraging equity futures, energy swaps, or buying collateralised debt obligations, you've strayed an awfully long way from what ordinary retail banks are supposed to do. The common feature of virtually all banking crises is this herd-like rush into instruments and markets, which, because they are not properly understood, are incapable of traditional risk assessment and balance sheet evaluation.

SocGen fell victim to a rogue trader, yet the losses incurred are symbolic of a wider malaise in the banking system which has seen practitioners pursue the illusion of easy profits in markets and instruments where they are peculiarly ill qualified to operate. In this regard, SocGen is certainly not alone. The guys at the top have little day-to-day understanding of what's going on underneath them. Controls and adequate risk assessment are correspondingly left wanting.

Greed certainly plays a part in this unthinking rush into the next big thing, but it is also in large measure simply the madness of crowds. Keeping up with the Joneses is always bound eventually to end in tears. SocGen is only the latest bank to find out the hard way that, despite the temptations, there may actually be something to be said for sticking to your knitting. Unfortunately for its managers, it seems unlikely SocGen will get the opportunity to mend its ways. A carve up between rivals now seems the most probable end game.

Markets enter overshoot territory

After another pummelling yesterday, either London share prices look extraordinarily cheap or there is a much more serious economic contraction coming down the line at us than most pundits are willing to predict. This is of course always the big imponderable in a correction or bear market. Is the stock market right to be discounting a severe deterioration in corporate earnings, or has it over-reacted as is often the case in a crisis and already overshot? By way of illustration, let's take the collapse in the share price of Royal Bank of Scotland, one of the biggest banking constituents of the FTSE 100. Banks are both the cause and most visible victims of the present crisis, so their shares have been hit far harder than most. Yet ignoring Northern Rock, none has been quite as badly hit as RBS, whose share price is now lower than at any time since its takeover of NatWest seven years ago. It is as if the value creation of this deal has been entirely wiped out.

Normally, the earnings multiple on a share price will always far exceed the dividend yield, yet in the case of RBS and many others this relationship has become bizarrely reversed, with the historic yield now at more than 9 per cent and the P/E down at a barely credible 5.5.

What these numbers tell us is that the market expects earnings to halve. Capital constraints dictate that at least the same level of earnings cover is maintained on the dividend payout, so in these circumstances the dividend is going to have to come down by at least the same amount too. There is also the possibility that RBS will have to raise more capital, diluting the existing shareholder base.

How likely are these outcomes? A very substantial fall in earnings both for last year and this now looks inevitable and only pride will keep the board from cutting the dividend. Banking regulators may also force a recapitalisation.

Yet the best guess has to be that, however bad it gets, it won't be quite as bad as the market is suggesting. An update from the Belgian bank Fortis yesterday seemed to confirm this prognosis. On capital, the dividend, and the scale of sub-prime losses, the bank was able to make some reassuring noises. Whatever. RBS shares on a historic dividend yield of 9.2 per cent look a rather better long-term bet than one of its own instant-access deposit accounts, where you will get just 4.2 per cent net for your money. The same goes for the market as a whole.

Dangerous dogs threaten regulation

The Commons Treasury Committee proposes to answer the supposed failings of the tri-partite arrangements for dealing with banking crises by adding a fourth super regulator on top to provide oversight and intervene when necessary. It is hard to see how this would help, given that it was confusion in regulatory command which contributed to the Northern Rock debacle in the first place.

In any case, the committee's main recommendation won't get more than a passing mention in the Government's own proposals for regulatory reform due to be published this week. Ministers must at all cost resist the temptation for Dangerous Dogs Act legislation. The focus must rather be on measures that will allow banks to go bust while at the same time protecting the interests of disadvantaged depositors. It was these inadequacies in the regulatory arrangements, rather than regulatory failure as such, which caused the Rock to become such a disaster for the Government.