There is no such thing as a rogue trader. So I wrote in Corporate Finance Review in 1996 in analyzing the Nick Leeson/Joseph Jett losses and their characterizations as wild cards in financial systems immune to the diabolical and risk management programs that can detect the slightest variation from the norm. But with Societe Generale’s former trader, Jerome Kerviel, racking up $7 billion in losses we are back to the same theory that emerges each time a trader defies internal controls and the brightest minds of the financial world. Nick Leeson was the rogue trader in 1995. Leesonracked up a$1.4 billion loss for his employer, Barings Bank,with a bad bet on the yen. The then-28-year-old Leeson bankrupted Barings, the bank that financed the Napoleonic Wars. In 1994, then-32-year-old Joseph Jett managed to find a computer glitch and use it to book nearly half a billion in phony profits from his bond trades at the now-defunct Kidder Peabody. And we can’t forget Brian Hunter at Amaranth, Iguchi at Daiwa, and Hamanaka at Sumitomo. Big trades, big losses. During the Enron era, we had rogues such as Andrew Fastow who spun debt off the books and Sanjay Kumar at Computer Associates who was the originator of the 35-day month for purposes of reaching revenue goals.
No internal control system is infallible. No audit or auditor can detect all system flaws. Even with certification of internal controls and all manner of SOX 404 compliance, we still have break-throughs. Mr. Kerviel knew a great deal about his bank’s internal control processes, knowledge that allowed circumvention. In-depth employee knowledge of internal controls systems is an oversight easily fixed by more frequent system changes. But, fix this lapse and there will be another breach by another bright mind with personal drive and ambition or just a need for cash.
The story at Societe Generale has emerged in the same way that it did at Kidder and Barings. At first announcement, the rogue acted alone. Then we begin to hear the rumblings of questions unanswered, signals unheeded, and inexplicable profits welcomed. There is a certain chutzpah in companies that act surprised given the number of flags and signals that unfold. Therein lie the real lessons of Jett, Leeson , Kerviel, Fastow, Kumar, and more. There is a glaring oversight in all internal control systems, one that no company or consultant has addressed competently. The systems fail to consider a touchy, feely, squishy element: humans perform jobs and part of effective internal controls is human observation, a qualitative task that offers no Excel spreadsheet or statistical Six Sigma. As one French expert phrased it, we have the most sophisticated home security alarm systems possible, and then we arerobbed because we forget to close the window.
So how do you accomplish the simple act of closing the window? Well, there are patterns among the so-called rogues. When the Kerviel, Jett, and Leeson misdeeds became public, there were the comments from those who knew them that run parallel to those we hear from neighbors of just-discovered serial cannibals, “He was a quiet man.” Leeson was odd and withdrawn. Jett had the self-perceived isolation of his race. And we are assured Kerviel was a loner who suffered from the insecurity of having taken his education at a lesser university. He wanted to be noticed, to be someone. The lack of engagement and self-confidence fuel the loner’s diabolical side. Embezzlement, fraud, and other financial tomfoolery that elude internal controls are easier when there’s no face on the harm and no interaction for accountability. And that sense of entitlement for the injustices they’ve endured make the trades that much easier with the rationalization of, “I’ll show them!” Misdeeds come, as they always have, from opportunity and need. Failed internal controls give the opportunity, and the quest for recognition, not the money itself, is the need. Indeed, Societe Generale’s assurance that Kerviel did not profit personally from the trades is verification of this principal and akin to the former Orange County Treasurer, Robert Citron. A government employee gains no percentage bonus from dumping public funds into high-risk derivatives. But he can become the toast of the community for a brilliant portfolio, at least until he bets wrong. Citron did, and Orange County rolled into bankruptcy.
There is a quasi-quantitative common factor that precedes the rogue downfall. All rogues perform well beyond expectations initially. Leeson was bringing in dollars as no one at Barings ever had, and all without a college education. Jett had increased the revenues in the Kidder bond department from 7% to 27% from 1992 to 1993. Bond markets are simply not that volatile. Citron was recognized nationally for his brilliant portfolio management of public funds. And Kerviel’s earnings and bonus seemed to defy the young trader’s IT background. In short, they were making money that should have raised eyebrows, if not audit red flags. One of the challenges any company faces is learning to ask questions when the news is good. Here the news was too good but no one was willing to ask, “How is this possible?” Blind concurrence is a root cause; rogue trader is the superficial and finger-pointing analysis. Rogues exist in fertile organizations that grant autonomy in exchange for performance.There is one more signal that emerges and re-emerges in these cases. These three and other villains who spin debt or financial yarns, and/or churn accounts, reach their pinnacles of access and power between the ages of 28 and 35. Perhaps this is the age when frustration from elusive success or the absence of recognition and accolades that their withdrawn existences deny them. But, the lesson is clear when you are in that age range, use caution. For your employees in that range, watch them carefully.A blind eye has allowed the rogues, the Enrons, the WorldComs, the Merrills and Countrywides of the subprime crisis. We emerge with childlike surprise from these multi-billion losses, always professing our, “Who knew?” We could have known if we focused less on systems and more on human nature, historical patterns, and our belief that rogues happen. Rogues do indeed happen, but not unless we turn a blind eye.
