THE BLOG
02/08/2008 06:11 pm ET Updated May 25, 2011

Rogue Finance

Globalized high finance has been shaken by yet another scandal. Société Générale (SocGen), the second-largest French bank, is in serious trouble due to the wild speculative transactions of rogue trader Jerome Kerviel. But this weekend in Tokyo, the ministers of finance and central bankers of the G7 will discuss another matter. Behind SocGen's colossal loss of 4.5 billion euros ($7 billion) there is another, much more serious crisis that the Kerviel affair has made it possible to hide. In mid-January, SocGen wrote off 2 billion euros of bad debt linked to the American subprime crisis. This phenomenal loss went unreported in the media because all eyes were focused on the French rogue trader.

Naturally, the financiers of the global village knew what was happening but kept mum. Privately many people judged SocGen's strategy brilliant: the publicization of Kerviel's losses provided a convenient smoke screen. Especially after the shock of the U.K.'s Northern Rock, bankers' worst nightmare is to share the humiliating destiny of the British mortgage lender. Hit by the subprime hurricane, Northern Rock was literally besieged by its British clients. Though saved from bankruptcy at the eleventh hour by the British government, Northern Rock is still looking for a white knight willing to buy it and to inject the necessary cash to keep it afloat. SocGen, on the contrary, has had no problems in employing Merrill Lynch to help recover Kerviel's losses. In finance, appearances count more than facts and SocGen knew that its bad management of the trading floor was a better crisis to publicize than taking a huge hit from the subprime global
meltdown.

This strategic consideration helps us to understand the "irrational" behaviour of SocGen during the last few weeks: the sudden denunciation of the rogue trader in the middle of the collapse of the world stock exchanges, which led to the maximization of losses for the bank. Only two weeks earlier Kerviel's portfolio had shown a profit of 1.5 billion euros. Now that we know that the young trader was used as a smoke screen, we can unravel another mystery: why did the complex system of controls that allows the bank to verify the total volume of transactions on a daily basis fail to detect Kerviel's irregular transactions? The answer is simple. All traders take excessive risks -- they regularly bet much more than they are allowed to. This is the common "unorthodox" behaviour of modern finance. Rules and controls are systematically ignored. This explains why last November SocGen ignored the recommendation of Eurex, one of the most important exchanges for derivatives, to check on Kerviel's trades. Just a few days ago, the European Union commissioner for trading, Charlie McCreevy, publicly condemned such behaviour.

The crisis of subprime lending is spreading to Europe because European banks have subscribed to the insane American mortgage boom. At the same time the crisis is beginning to erode the ethics of the banking system. Those who administer our savings renegotiate the rules of the game daily, ignoring the system of controls. The fear of the domino effect (already felt with the U.K.'s Northern Rock), in which the failure of one bank would prompt the bankruptcy of many others -- all intertwined through subprime loans -- justifies manipulations such as the construction of the Kerviel scandal.

How many people are aware of this reality? And how many bear some responsibility? In the pubs and restaurants of the City of London people whisper that the responsibility lays well beyond the board of directors of SocGen. The crisis of the subprime market is imposing a new code of conduct on high finance, a set of new rules that nobody likes because these rules are replacing transparency -- a key characteristic of globalized finance -- with a maze of smoke and mirrors. Everybody feels at risk: "Today Kerviel was the fall guy, tomorrow can by someone else, one of us," traders say to each other.

The real danger, however, is that obscuring one crisis with another, instead of protecting people's savings, may end up wiping them out. To hide a loss of 2 billion Euros in the subprime market, SocGen ended up losing another 4.5 billion. The shocking reality that the G7's financial mavens will need to face this weekend is not the discovery of yet another rogue trader but the rise to power of rogue finance.